When it comes to retirement planning, many rely on ‘rule of thumb’ calculations and assumptions; the likes of which we often see dotted across retirement fund communications or in financial services awareness campaigns.
These rules of thumb, such as how many multiples of your annual salary you’ll need at retirement, what percentage of your salary you should contribute to a retirement fund, and how much capital you should have by a certain age can be misleading and, possibly, even dangerous.
Let’s explore why these assumptions often fall short.
Income replacement ratio
The percentage of your final salary that you wish to receive as an annual retirement income.
General rule of thumb: 75%
Why it’s problematic: Actual income replacement ratios can vary greatly depending on the lifestyle you want in retirement. We have seen clients’ income needs drop by more than 50% in retirement, while for others it increased. A small variation to this ratio can significantly impact your financial outcome.
Longevity
The number of years you will need a retirement income.
General rule of thumb: 20 years
Why it’s problematic: Planning for a 20-year retirement might be reasonable if you retire at 75. However, many people aim to retire before 65, and with increasing life expectancies, a funding period of 30+ years is more realistic. Using the traditional longevity assumption might result in severe underfunding in retirement.
Investment returns
General rules of thumb: Typically, pre-retirement investment returns of inflation plus 5% per annum and post-retirement investment returns of inflation plus 4 to 5% per annum are assumed.
Why it’s problematic: Assuming an investment return of inflation plus 5% per annum may be unrealistic. Many corporate retirement schemes underperform this benchmark, and only some retail unit trusts consistently achieve it. Furthermore, the impact of investment administration and financial advice fees must be considered. A more conservative assumption is advisable.
Taxes
These assumptions are based on ‘straight line’ calculations and do not account for taxes. The targeted income is gross of income tax, and any tax payable on retirement fund withdrawals is not considered.
Retirement
General rule of thumb: At age 65
Why it’s problematic: It is increasingly common for people to choose not to retire, per se, but to focus of making work optional. Many older professionals also feel they have much to contribute and may choose to work, albeit it at a slower pace, well beyond 65. Similarly, some business owners may never retire, opting to serve in a non-executive role on the company’s board, earning director’s fees and/or dividends.
Income withdrawal rate
The rate at which you withdraw income from your retirement capital.
General rule of thumb: 4% to 5% per annum.
Why it’s problematic: It assumes you only have traditional retirement capital as a source of funding (for example, a pension fund or retirement annuity) with no other income sources. In reality, additional income (like for example, rental income) reduces the retirement capital required.
To illustrate how impactful this is, for every R4,000 net income you earn in retirement, you need about R1,000,000 less in capital. That means if you earn net rental income of R10,000 a month, you need about R2,500,000 less in accumulated capital.
The dangers of relying on rules of thumb
When I was younger and did my medical aid health screening annually, in pursuit of rewards programme points, the assessment report would warn me that I was on the brink of obesity and needed counselling. However, I was very lean at the time. They were wrong! The provider used rules of thumb for the calculations and the results were way off the mark every year.
I can only imagine how damaging this ‘feedback’ might have been had I been suffering with body dysmorphia or an eating disorder.
Similarly, financial rules of thumb use averages that may not apply to your unique situation. Benchmarking yourself against these averages might lead to anxiety, fear of the future, or hopelessness.
The value of personal financial planning
Instead of relying on generic rules, personal financial planning, offered by a licensed financial planner, considers your specific circumstances, goals, and needs. This approach helps you make informed decisions and avoid the pitfalls of one-size-fits-all assumptions.
While rules of thumb can provide a rough guideline, they are simply inadequate for actual retirement planning. Personal financial planning offers a more accurate and tailored approach, ensuring you can achieve your retirement goals with confidence.
But if you still intend to live by these rules of thumb, please be careful… or maybe just average.