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Should rules of thumb be used to plan for retirement?

Published May 13, 2022


By Thandi Skade

As an investor, you may come across many different rules of thumb along your investment journey. These may help you make sense of how much you will need to invest to avoid outliving your retirement nest egg. However, it is important not to lose sight of and account for your individual circumstances.

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Examples of rules of thumb

The Rule of 120 is a calculation that uses your age to determine the supposedly appropriate asset allocation for your investments: The formula tells you to subtract your age from 120 to discover the percentage of equities you should hold. For many, this may make sense, given that the older you get, the lower your capacity to take on risk.

Then there is the 4% Rule. Since the mid-90s, this has been applied universally as a rule of thumb to determine the appropriate drawdown rate and asset allocation for retirees. It suggests that if you withdraw 4% of your capital in the first year of retirement and only adjust for inflation each year thereafter – and provided that you maintain a minimum 50% allocation to equities – the risk of outliving your retirement savings over a 30-year period is substantially reduced.

Another popular formula provides an estimate of the amount of time it will take an investment to double in value. The Rule of 72 suggests that by dividing 72 by the interest earned on your investment each year, expressed as a percentage, you will get a figure that represents the number of years it will take your investment to grow twofold.

Add a pinch of salt

While these rules of thumb provide us with a starting point to guide our thinking and planning, the trouble with them, and other statements that equate averages with certainties, is that they are by nature based on assumptions and metrics applied to the average person or “typical” circumstances. The notable flaw of rules of thumb is therefore that they cannot account for every investor’s unique circumstances.

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Consider two 35-year-old investors who are both married with two children and plan to retire at the age of 65. Thabo is the breadwinner with a stay-at-home wife. Mark has a salaried wife with parents and relatives dependent on them. While Thabo and Mark’s investment horizons look the same, their profiles are clearly very different. As an investor facing greater short-term financial obligations, Mark’s appetite for risk would likely be more conservative than Thabo’s, given that Thabo’s circumstances potentially leave him in a better position to absorb short-term market shocks.

If one applied the Rule of 120 to Mark and Thabo’s profiles, both should have 85% of their portfolios invested in equities, but given Mark’s responsibilities, this allocation may not be appropriate. Thabo’s situation is also not without risk. As the sole breadwinner in his household, the consequences of falling ill or losing his job could have a devastating impact on his family – a factor that will also influence his risk appetite.

And what about investors who start saving for retirement late in life? A formula that de-risks your exposure to equities as you get older may not be the optimal choice. This is why, in investing, rules of thumb should always be considered with a pinch of salt.

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This holds true for even the more well-known rules.

While the 4% Rule can be a good starting point for investors entering retirement, the formula may not be applicable to every investor. For instance, those who plan to delay their retirement date and work longer might not need an income for 30 years, while others may prefer to start on a higher drawdown rate and reduce their real income over time by taking below-inflation increases.

Over the past two years, we have witnessed, and many have experienced, how unexpected events or phenomena, such as the Covid-19 pandemic and the global ramifications of the Russia-Ukraine conflict, can drastically alter our financial status. For retirees, unexpected expenses could force some to deviate from the inflationary increases, and return fluctuations could mean that some may need to draw down lower income increases due to muted returns, and vice versa when strong returns are generated.

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With the Rule of 72, it is impossible to predict what the future rate of return might be. A far better approach to doubling your investments would be, where possible, to increase your contributions.

Rather than anchoring on formulae that may not be appropriate, focus on aspects of your financial plan that you can tweak and change to give you a better chance of retiring comfortably. It is also advisable to consult a good, independent financial adviser, who can help you devise a financial plan that takes your personal circumstances, financial obligations and personal inflation into account.

Thandi Skade is a communications specialist at Allan Gray