These conventions became "rules" for a reason, but investors need to customize these rules to their circumstances, says Morningstar's Christine Benz.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Many investors use rules of thumb to help guide the retirement portfolios. I'm here with Christine Benz--she is our director of personal finance--to look at a few of these rules of thumb and also when it's appropriate to flout them.
Christine, thanks for joining me.
Christine Benz: Jeremy, it's great to be here.
Glaser: Let's start with the first one about figuring out your bond/stock mix. There is a rule out there that you should take a 100, subtract your age, and that's how much you should have in stocks. Does this strike you as a good jumping-off point for figuring out your asset allocation?
Benz: I think it's better than nothing. You often hear Jack Bogle saying to use this really intuitive idea for figuring out whether your asset allocation is in the right ballpark. It's based on a really simple principle, which is that as you get closer to needing to spend your money, you need to secure that money in safer securities like cash and bonds, because the shorter the time horizon, the greater the likelihood that you could have a negative result by holding stocks during a very short time horizon.
So, it's based on a very intuitive idea. I think it's a decent starting point for people who have no idea about where to start with their asset allocations. But certainly for people getting close to retirement, it really does make sense to think about your anticipated spending needs from that portfolio and let that, more than anything, drive your asset allocation.
So, if you are a retiree who is lucky enough to come into retirement with, say, a pension and Social Security, and those two sources together are supplying most of your needed income while just sipping from that investment portfolio, for that sort of person, a more aggressive asset allocation probably makes more sense than using 100 minus your age to drive the equity allocation. So, definitely take a step back and think about your own individual spending needs from that portfolio rather than just taking that rule of thumb and running with it.
It's also really important to factor in your own risk tolerance. If you're a person who has examined your past behavior in past down markets and you've seen that you really freaked out during previous down markets--you completely upended your investment plan at the worst possible time--if you're a person with a history of behavior like that where you know that your risk tolerance is not good, I think it does make sense to perhaps have an even more conservative equity allocation than prescribed by that rule of thumb.
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Glaser: One rule that's been somewhat controversial recently is the 4% rule--the idea that you can safely withdraw 4% from your retirement portfolio every year. Is this a reasonable starting point, just like the 100-minus-your-age rule?
Benz: I think it is. In fact, a lot of financial planners have recently taken a close look at the 4% rule. First of all, I think it's important to understand exactly what the 4% rule says retirees can do. The basic idea is that the retiree wants a fairly static stream of income in retirement. So, you're taking 4% of your initial balance in year one of retirement, and then you are gradually inflation-adjusting that dollar amount as the years go by.
The research around the 4% rule, as I just stated it, said that the retiree would have a roughly 60% equity/40% bond portfolio and that the time horizon was roughly 30 years. So, certainly for retirees who have a situation that does not resemble those assumptions in any way, shape, or form, they should think about doing something other than that 4% withdrawal rate.
So, if they have, say, a shorter time horizon than that 30-year time horizon, they may think about taking an even higher withdrawal rate. In fact, our colleague David Blanchett, who is head of retirement research for Morningstar Investment Management, has suggested that retirees think about using the required-minimum-distribution tables that the IRS publishes to guide their withdrawals because they are based on the assumption that, as your life expectancy shrinks, you should be able to take a larger share from your portfolio.
Certainly, if you have a higher allocation to stocks, you may be able to take a slightly higher withdrawal than 4%; but certainly, if you have a more conservative portfolio mix, you'd want to be more conservative about your withdrawal rate.
Glaser: If that rule gives you a sense of how much you can withdraw safely from your portfolio, it still leaves the question of how much income you'll actually need--and hopefully the two are close together. The rule of thumb there has been that you'll need 80% of your working income in retirement. Does that strike you as a reasonable jumping-off point?
Benz: People often talk about this 80% income-replacement rate, and I think it comes down to an analysis of your own savings pattern while you were working. Say I was a person who made it a point to save 25% of my income year-in and year-out, certainly since I won't be saving that 25% of my income anymore while I'm retired, I can get away with a lower income-replacement rate than 80%. I'd have a 75% income replacement rate from the get-go, and I may be able to make additional lifestyle changes to drive that down even further.
So, you want to look at your own spending pattern while you were working as well as any anticipated changes in your spending when you are retired. Take a close look at whether there will be any major lifestyle changes--or even small lifestyle changes--that will change your spending patterns. A big-ticket item, I know, for many retiree households is downsizing. They are thinking about moving to a smaller place, so that will mean maybe lower maintenance costs, lower utility costs, lower taxes. So, take a close look at your in-retirement budget, and that certainly gets easier as retirement draws near. You are much closer to what those expected expenditures will be like. So, the 80% income-replacement rate is a decent starting point, but it's best to customize the number.
Glaser: It sounds like these rules of thumb became rules for a reason, but it's still important to take your personal circumstances into consideration.
Benz: Definitely customize all of these numbers.
Glaser: Christine, thanks so much for your thoughts today.
Benz: Thank you, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.
