3 Of The Most Common Half-Truths In Retirement Planning

There are countless articles written every day offering insights and advice about financial/retirement planning. With so much information available you would think that anyone interested in reading those articles could easily become an expert (near expert?) on the subject. The problem - and I'm sorry to say this - is that many of the people writing those articles are hardly well informed on the subject. Many have no financial credentials and are just cobbling together random quotes from their sources and presenting generalizations and half-truths as "rules" and best practices to follow. This makes it difficult to distinguish between what you should pay attention to and what should be avoided. Let's take look at three of the most recited "half-truths".

Use The 4% Rule To Make Sure That You Don't Outlive Your Savings
In 1994 William Bengen created what’s now known as the “4% rule”. It was never intended to be a "rule" at all, but rather a guide to show what actions would result in a high likelihood of not outliving your savings. His research suggested that if you withdraw 4% of your retirement savings in the first year of retirement and then adjust your withdrawals for inflation in each consecutive year (4% plus the rate of inflation), your savings should last through retirement (or ~30 years). This theory works, but only if his assumptions are consistently applied, which is why this is a half-truth. For example, Bengen used a portfolio of 60% stocks and 40% bonds (is this the way your portfolio is set up? If so, will it always remain this way?). Back then (and up through 2011) bonds earned 5% or more annually. Since 2011, they have returned ~ 2% or less annually. This lower return generates less earnings and puts his theory at risk. Also, if there are years that your total investments earn less than the historical average that he assumed, the chance of outliving your savings increases significantly. Your investments will also never generate a perfectly consistent return from year to year for 30 years. When and how much your returns vary can seriously impact your long-term results so using a flat (average) rate for all years will likely give you false results.

This brings up another important consideration - the 4% rule does not allow for any flexibility in withdrawals. If your returns are lower than expected at any point, you can't vary your withdrawal amount. Theoretically, this could be offset by greater than expected returns in other years, but that variance between years would have to be calculated carefully to account for timing (the variance at different points of retirement) and the increase/decrease in expected earnings in any given year. Not only is that complicated to keep track of (and what if you are half way through retirement and find that you are falling short?), but even starting out with bonds currently earning less than 2% annually doesn't bode well for a successful outcome.

Also, what good is this "rule" if a 4% (inflation adjusted) withdrawal rate is not sufficient to pay your expenses? Remember that any withdrawal will incurr tax liability (if it's not from a Roth account), reducing the spendable portion of the withdrawal. How much you withdraw is not nearly as important as how much of the withdrawal is actually spendable.

A Better Option:
Rather than blindly following this rule (of thumb), take a good look at your investment style, risk tolerance, and actual past results to determine a conservative return rate for your retirement years. Take into account whether your current preferences will remain intact throughout retirement, or if they may change (become more conservative?) as you age. Also, try not to assume a flat return rate for all years (unless it's very conservative). Neither the Dow Jones Industrial Average or the S&P 500 has ever had more than 9 years in a row of positive returns and that has only happened once for each (stretches of 3-5 years of positive returns is more common). To help stress test your results, pepper in a few years of mildly negative returns (minus 2-3% every 4-5 years?) to see the effect of a less than optimistic outcome. It's nice to hope for the best, but you need to be prepared for less than stellar results. The markets have never had positive returns every year for 30 years, and you aren't likely to either.

It's good to be aware of the "4% rule", and it may even help you to establish some useful guidelines, but make sure that you understand its limitations and build your financial plan around the most realistic circumstances possible.

Wait Until Age 70 To Claim Social Security

Every year you delay claiming Social Security after your Full Retirement Age (age 66 if born before 1960, otherwise age 67), your benefit will increase by ~8%. This continues up to age 70 when you would reach your maximum benefit amount. This increase in benefits is why you see so many recommendations to wait until age 70 to claim Social Security. While this information is accurate, it is too simplistic to act on by itself and, therefore, is a half-truth.

Roughly speaking, the break even point between claiming at age 62 and receiving smaller checks or claiming at age 70 and receiving your maximum benefit amount is around age 80-81. Rather than basing your decision on a benefit amount alone, you should also consider how soon you may need Social Security to help pay your bills, and your life expectancy. If you are in good health, will not need to rely on Social Security for income before age 70, and your family has commonly lived into their 80's, waiting to receive the largest benefit possible may be a good idea. If all of those considerations are not true, it is best to adjust your claiming strategy based on your needs, health and life expectancy. If you are married, there are several additional strategies to consider, depending on your respective ages and individual benefit amounts, that may help you to maximize your income potential. The Social Security website (www.ssa.gov) can help explain your options in detail. Make sure to take your time making this decision as it will affect the income for both spouses for the rest of your lives.

A Better Option:
In short, there is not just one right answer to determining when you should claim Social Security. Just like creating a financial plan, everyone's circumstances and needs are unique. The best course of action is to make sure that you understand all of your options so that you will be comfortable with your decision in the long run.

* Currently, Social Security is expected to remain solvent until 2034 (that year is subject to change). After that, if nothing changes, it is expected to need to reduce future benefits by ~25%. It is unlikely that those already receiving benefits at that time will be affected, but it is unclear how others may be affected. If you are at least 62 before 2034 you may want to plan on claiming benefits before any reductions take place to lock in your benefit. Claiming at age 62 with no reduction in benefits is very similar to claiming at age 67 with a 25% reduction.

** Keep in mind that if you decide to retire and claim benefits at age 62 (for example), you will have 3 years until you are eligible for Medicare at age 65. During these years you will have to find private health insurance, which can be quite expensive. These costs should be factored in to your decision about when to retire, and about when to claim Social Security.

Plan On Replacing 75% Of Your Income

(most articles suggest 70% - 80% so I split the difference)

A common recommendation is to plan on replacing 75% of your current income in retirement. This is presented as a savings goal. Theoretically, as long as your spending does not increase in retirement over current levels, this should provide for a comfortable retirement since you are presumably living on this amount now. That may be a fair assumption, but is replacing that much of your income necessary? This is where this advice can become a half-truth.

For the sake of round numbers, let's assume a salary of $100k/year. Replacing 75% of that in retirement, or $75,000 for 25 years, would amount to needing $1.875M in savings. Is that realistic? In very general terms, with a salary of $100k you may have pre-tax deductions of 14% ($14,000), consisting of 10% going to your 401k and 4% for employer sponsored health insurance. This means that you will be taxed on $86,000, or $61,200 after a standard deduction ($24,800) for a married couple. You may pay approximately $9,500 in Federal and State tax (using a 3% State tax rate), and another 7,000 in Medicare and Social Security taxes. This leaves you with take home pay of ~ $69,500/year ($86,000 less $16,500). Because you are a good saver, $2,500 of that (~3.5%) is saved for college, an emergency fund, or other savings. This means that you are living off of $67,000/year, or 67% of your salary.

If your expenses stayed perfectly constant throughout retirement (they won't), you budgeted perfectly and spent your last penny on the day you died (you won't), and you knew that you would die in exactly 25 years (not likely), you would need $1.675M in savings to get through retirement ($67,000 x 25 years). If you wanted to be able to actually spend $67,000 per year, you would need $1.805M because you would need approximately $130,000 to pay for taxes on your annual withdrawals. That's in the ballpark of the original recommendation of needing $1.875M, replacing 75% of your salary.

However, you are most likely to be eligible for Social Security benefits. The average benefit is approximately $1,400 per month, and a non-working spouse (who is not eligible for their own benefit) is eligible for 50% of their spouse's benefit. This would provide a one earner household with income of $25,200 per year ($2,100/month).

This means that you would need $41,800 per year from savings (before taxes) to pay your expenses of $67,000 ($67,000 - $25,200), or a total of just under $1.05M over 25 years. This increases to ~$1.125M if you include taxes on withdrawals. That's $675,000 less than the $1.8M anticipated above, requiring you to replace only 45% of your $100,000 salary instead of the 75% ($1.875M) original recommendation.

This is a very simplistic example (inflation and investment returns are not included), with a lot more details that could be considered, but believing that you will need savings that will replace 75% of your salary in retirement is most likely misleading. If you don't need 75% of your salary to live on now, why would you need to replace 75% of it in retirement? It is certainly wise to be well prepared, but advising someone with a $100,000 salary to save $750,000 more than they will likely need is overkill.

A Better Option:
It is critical to run your own numbers and not follow generic advice. Instead of listening to the media and/or taking financial advice from your friends and neighbors, create an individualized financial plan that accounts for your unique needs and circumstances. If you feel more comfortable getting a second opinion (it works well for medical issues, and it can work just as well for financial matters), speak with a financial adviser and use your own financial plan as a starting point. Financial articles may provide food for thought, but they are meant for everyone and no one in particular. Don't let yourself be guided by others when your financial well-being is at risk.


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