4 Retirement "Rules of Thumb" That Actually Work

By Damian Davila on 9 May 2017 0 comments

Planning for retirement can sometimes feel daunting, but there are ways to temper these worries. Over the years, financial experts have come up with several useful rules of thumb that can help you get your finances organized. To be sure, there is no one-size-fits-all approach to retirement savings, but these strategies are a great place to start.

1. The 50/30/20 rule

You may know Senator Elizabeth Warren for her fiery speeches on and off the floor of the U.S. Senate, but she is also a serial author with 12 books under her belt. Teaming up with her daughter, Amelia Warren Tyagi, Warren provides practical budgeting advice in All Your Worth: The Ultimate Lifetime Money Plan.

The golden nugget from Warren's book is the 50/30/20 rule, which suggests that you split your budget into three buckets:

  • 50 percent to pay for must-haves, including rent or mortgage payments, groceries, and minimum debt payments;
  • 30 percent to cover non-essentials, such as going to the movies or on vacation; and
  • 20 percent to save for retirement, build an emergency fund, and make additional debt payments.

The 50/30/20 rule has become very popular because it strikes a balance between wants and needs, and provides a simple approach to setting your monthly budget. Assuming a monthly paycheck of $2,800 after taxes, you would allocate $1,400 ($2,800 x 50 percent) to needs, $840 ($2,800 x 30 percent) to wants, and $560 ($2,800 x 20 percent) to debt and/or your retirement fund.

2. At least 10 percent of your income to retirement savings

There's another rule of thumb for how much of your income should go specifically toward retirement. According to many financial advisers, you should contribute at least 10 percent of your paycheck to your 401(k), IRA, or workplace savings plan.

Why is 10 percent a rule of thumb? One possible explanation is the ease of calculation: Just take out a zero. With a gross monthly paycheck of $3,500, you know that you have to contribute $350 to your retirement account. Easy!

A caveat here is that you should be doing this for as long as you are working, starting as soon as possible. Young retirement savers will benefit the most because of compounding interest. The more that you contribute to your retirement account in your early working years, the more time the funds will have to grow.

3. The 90/10 rule from Warren Buffett

In 2013, legendary investor Warren Buffett revealed that he ordered the trustee of his estate to allocate 90 percent of his cash to a very low-cost S&P 500 index fund, and the remaining 10 percent to short-term government bonds. "I believe the trust's long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions, or individuals — who employ high-fee managers," he concluded. (See also: Why Warren Buffett Says You Should Invest in Index Funds)

This advice didn't go unnoticed by investors. Between 2011 and 2016, investors took $5.6 billion out of actively managed funds, which attempt to beat the market, and dumped $1.7 trillion into passively managed funds, such as index funds. As the name implies, index funds simply aim to generate a return equal to the index they're tracking, such as the S&P 500, after fees.

Putting 90 percent of your retirement savings in a low-cost index fund greatly minimizes your investment costs, since the expense ratios (the annual fees charged to shareholders) are much less than for actively managed funds. This means more money is left in your account to grow, and therefore you increase your chance of hitting your savings target. Some equity index funds have annual expense ratios as low as 0.05 percent, and those tracking the S&P 500 had an average annual return of 8.65 percent over the 2007–2016 period.

As you get closer to retirement age, you may want to consult with a financial professional on how to adjust your portfolio allocation according to your changing needs.

4. The 4 percent rule

After testing a variety of retirement withdrawal rates using historical rates of return, financial planner William Bengen determined that four percent was the highest rate that held up over a period of at least 30 years.

Here's how it works: Assuming a $600,000 nest egg, you would withdraw $24,000 in your first year of retirement. In the second year, you would withdraw the same amount plus extra to cover inflation. Assuming an annual rate of inflation of 2.5 percent, your second and third withdrawals would be $24,600 and $25,215, respectively.

While the four percent rule is not without critics, nor is it the perfect calculation for everyone, it continues to help retirees plan ahead the size of their withdrawals during their retirement years. Just make sure that once you reach age 70 ½, you meet your required minimum distributions (RMDs) set by the IRS. Some years you may have to withdraw a bit extra beyond your planned four percent to avoid the hefty 50 percent tax penalty for failing to take your scheduled RMD.

The bottom line

These four rules of thumb can give you a leg up on your retirement strategy. However, think of them more as guidelines and not so much as commandments. Every financial situation is different, so make the most of the available information and resources through your employer-sponsored retirement plan. Consult a financial adviser whenever necessary. (See also: Who to Hire: A Financial Planner or a Financial Adviser?)

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