Interactive Investor

Can these four ‘rules of thumb’ help you reach your retirement goals?

Craig Rickman examines some common retirement guiding principles and analyses how effective they are.

7th December 2023 10:27

Craig Rickman from interactive investor

Whether you’re saving for retirement, or drawing an income in later life, making the right decisions is not only tricky, but there’s a lot at stake. The wrong step might be the difference between achieving the lifestyle you want and having to make sacrifices.

As the pension and investing landscape can be a labyrinth at times, even experienced savers and investors can benefit from a nudge in the right direction.

To provide some approximate steer on how you should approach big retirement choices, several rules of thumb have been developed. These guiding principles explain how much you should save based on your age and income, determine suitable asset allocations for your stage in the savings cycle, and suggest how your retirement income strategy can last a lifetime.

But how accurate are they? And can blanket guidance really put you on track to meet your retirement goals given financial planning is a deeply personal affair?

Here I explore four common retirement rules of thumb and unpack how effective they are.

1) A ‘safe’ withdrawal rate?

Since pension freedoms was introduced in 2015, the way people choose to draw retirement income has undergone a major shift. Annuities, where you trade your pot for a guaranteed income, have fallen out of fashion, with retirees instead favouring the flexibility offered by drawdown.

But when you opt for drawdown, with either some or all your money, you are tasked with ensuring your retirement pot lasts the distance.

Something that aims to help you get this right is the 4% rule. Also known as the safe withdrawal rate or Bengen rule, it determines that if you draw 4% of your total investment portfolio - typically pensions, individual savings accounts (ISA), general investment accounts (GIA) - in retirement, adjusted annually to account for inflation, your pot should last 30 years or more. Unless you plan to retire in your 50s, this should be more than adequate to see you through.

But the Bengen rule by no means offers cast-iron certainty – there are many unknown future variables that can impact whether 4% withdrawals will avoid draining your portfolio too soon.

Chief among the problems with this strategy is that, in absence of a crystal ball, investment performance is impossible to accurately predict. And if your portfolio gets off to a bad start, continuing to draw 4% could mean your pot drains quicker than planned.

That said, 4% a year isn’t an overly aggressive withdrawal rate. It can certainly be a good starting point, so long as you review where you are annually to make sure any withdrawals are sustainable. What’s perhaps more important is selecting the right assets to draw income from at the right time.

For instance, continuing to encash shares when markets are low can hamper the longevity of your retirement portfolio. Instead, you might want to pause withdrawals and dip into your cash holdings until things improve.

2) A guide to sensible asset weightings

Finding the right asset mix is core to any sound investment or retirement portfolio. The 100 minus your age rule aims to help you get these weightings right.

So, how does it work? Well, it implies that if you deduct your age from 100 you should have the optimum portfolio split between shares and bonds.

For example, a 20-year-old should allocate their portfolio 80% to shares and 20% to bonds. But if you’re age 60, the weightings should be 40% and 60% in shares and bonds, respectively.

The idea is that you can afford to take more risk when you’re younger, as you have more time to ride out the market ups and downs - so equities should form the bulk of your portfolio. But as you move through life, and have reduced capacity to bear investment losses, a higher bond weighting will provide added stability.

This rule can provide some useful steer on how much risk you should take based on your investment time frame. Investing too conservatively can be harmful when retirement is still decades away.

However, there are some flaws with this approach. First, your personal attitude to risk and investment experience plays a fundamental role in asset weightings. A sophisticated 50-year-old investor is unlikely to see sense in allocating 50% of their portfolio to bonds.

Second, the rule restricts holdings to shares and bonds, ignoring other useful assets such as commodities and cash, which can offer your portfolio some useful diversification.

And third, shares and bonds aren’t always negatively correlated, as many investors found out the hard way during 2022 when both asset classes tanked.

3) How much to save based on your age

Wouldn’t it be great if we knew exactly how much we needed to save to secure the retirement we want?

Well, the 50% rule claims to provide the answer. The rule states that you should save a percentage of your salary equal to half your age to set enough aside for a comfortable retirement.

Clearly this benefits those who start early. According to this rule, a 20-year-old will need to pay 10% of salary into a pension, and employer contributions count too. Under auto enrolment, if you pay 5% of qualifying earnings into a pension, your employer must pay 3%, which means you won’t be far off. If your employer offers to pay more, which many do, then consider making the most of this – if affordable of course.

The 50% rule is certainly a good starting point, but the lack of personalisation is an obvious snag. A comfortable retirement can mean different things to different people. You may need to deviate from a one-size-fits all approach.

As with some of the other guiding principles examined here, unknown future variables are omitted. Saving for retirement isn’t just about how much you save, but also what investments you choose. There is no guarantee these will perform as you expect. However, using a pension calculator to check where you stand every year can give greater clarity on whether you’re saving enough.

One final point is that the 50% rule also loses its efficacy as you age. For example, if you leave retirement planning until age 60, ploughing 30% of your monthly salary into a pension is unlikely to get you where you need to be.

4) How quickly will you double your money?

The rule of 72 is a mathematical formula that estimates the number of years it takes to double your money at a fixed annual rate of interest. You simply divide your return by 18 to get the answer.

So, for instance, if your annual return is 3%, it would take 24 years (72/3 = 24) to double your initial investment. Importantly, it includes compounding, so only works if the return in question – which could be either interest or dividends – is reinvested.

It’s a handy calculation, especially if you aim to save a certain pot size by a certain point. Even if you don’t have a specified rate of return, you can divide the number of years by 72 to work out the annual growth you need.

The main drawback here is that fixed interest returns may only be guaranteed for a certain period. It’s highly unlikely the same annual rate will be maintained consistently over many years.

There are some other things to think about, such as inflation. Let’s say your return is 7%, it would take roughly 10 years to double your money. However, if inflation averaged 3.5% over this period, the real value will be far lower. Tax and charges will also eat into your final figure.

On the plus side, the calculation doesn’t consider additional contributions, which can make a sizeable difference - especially once you include up front pension tax relief, which could be as much as 45%.

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