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Personal investing

Should rules of thumb be used to plan for retirement?

There are several rules of thumb that are referred to in investing. Many of them have become widely accepted standards for determining how much to save for retirement, how much income to draw down during retirement, and how assets should be allocated during different life stages. But do these rules of thumb hold true for you on an individual level? Thandi Skade explores this proposition.

Each day, we are confronted with problems to solve and faced with hundreds of decisions that need to be made – some that can be taken on the fly and others that require more careful consideration. Rules of thumb, or heuristics, as behavioural scientists refer to them, are useful mental shortcuts that simplify complicated matters and reduce the amount of time it takes us to make decisions.

In the context of investing, rules of thumb can help guide the way we think about and approach important life considerations, like setting financial goals and planning for a comfortable retirement. However, as we illustrate with a few examples below, rules of thumb should not be considered hard and fast instructions, but rather broad and general guidelines.

Examples of rules of thumb

Consider the Rule of 120, 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.

… rules of thumb should not be considered hard and fast instructions, but rather broad and general guidelines.

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 the rules of thumb mentioned above 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. Averages themselves are problematic – think about the anecdote of the man who attempted to cross a river that was, on average, knee-deep, only to drown in the section that was much deeper than the average.

Bringing this back to investments: 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.

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.

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 and leverage the power of compound interest to grow your investments.

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 (as described below). Resources like the Allan Gray investment calculator can help you determine what your current investments could be worth in the future. 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.

Boost your retirement savings with these pointers

Saving for retirement can feel like an insurmountable balancing act to pull off in the face of escalating living costs and the rising inflationary environment we currently find ourselves in, but fortunately, there are a few levers we can pull to help us get it right.

… it is important not to lose sight of and account for your individual circumstances.

Beware of the lifestyle creep and plan for lifestyle inflation

As retirement savers, we face two types of inflation: the rising cost of goods and services, and lifestyle inflation, which refers to the changes in your standard of living over time as you progress in your career and your earning potential improves. Generally speaking, the more we earn, the more we spend, but it is important that we not only plan for future price increases, but also plan for future increases in our expenditure. This means upwardly adjusting your retirement saving contributions every time your salary increases.

Prioritise your retirement savings

Whenever you receive a lump sum, consider dividing the windfall between your daily and long-term needs. If you are fortunate enough to receive more than one lump sum windfall in a year, you could also make alternating contributions to the two pots. You can also supplement your retirement savings with a tax-free investment account or a unit trust. These will give you more flexibility in terms of the funds you are invested in and accessing your investments.

Decrease your expenses before retirement

Focus on paying off big-ticket assets like your home and car well before you reach retirement age, as this will significantly reduce your expenditure bill in retirement. If you can, it is advisable to start downsizing your lifestyle ahead of retirement or eliminating excessive costs and expensive debt.

Careful planning is key

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, but it is important not to lose sight of and account for your individual circumstances.

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