September, 2010
By Michael Kalscheur, CFP®
Senior Financial Consultant, Castle Wealth Advisors, LLC

If you have ever read a financial self-help book, they will always give you “rules of thumb” that you can refer to when getting a feel for a particular issue or part of your finances.

One of the popular rules of thumb (especially among life insurance agents) is that you should own 10x your annual income in life insurance. As rules of thumb go, this works pretty well for people in their 20s, 30s and 40s. Unfortunately, agents forget the other important rule of thumb when it comes to life insurance: buy term and invest the difference.

One of the newest rules of thumb is something called 10/10/4. If you are not familiar with it, this rule applies to retirement. Here are what the three numbers represent:

  • 10 – Save 10% of your annual income for retirement every year.
  • 10 – When you retire, have 10x your annual income in a retirement nest egg.
  • 4 – When you retire, don’t withdraw more than 4% of your nest egg annually.

On their face, these recommendations seem reasonable. However, does this make sense for most people? Is this a good rule of thumb? Let’s look at each item.

1. Save 10% of your annual income.

This is a great starting point, especially for people just starting out in their 20s and early 30s. By saving 10% in a 401k or 403b through work, you save money for retirement before it ever shows up in your checking account. This is one of the best ways to get accustomed to saving without even thinking about it.

This means that for someone earning $60,000, they would be saving $6,000 per year. Assuming no raises and a compound return of 8%, you would have about $300,000 after 20 years and almost $750,000 after 30 years. If you include just a 2% annual raise, this number jumps to $350,000 and almost $900,000 respectively; a significant nest egg even after taking inflation into consideration.

Another way of thinking about this from a retirement standpoint is that by saving 10% of your income, you are living on 90%. Therefore, when you retire, you don’t need to replace all your income, but only 90%. It’s much easier to replace $54,000 of income than $60,000.

Saving 10% of your income also has ancillary benefits. If you are using a 401k or 403b, your 10% is taken pre-tax, saving you on state and federal income taxes every April 15th. Also, saving 10% will most likely maximize your company’s matching program (if they have one). That means that your 10% will be closer to 12% or 13%, further enhancing your retirement savings.

However, is this a good rule of thumb? The answer is yes, if you are in your 20s or 30s. If you have missed the boat and delayed saving for retirement until your 40s, you’ll need to save significantly more than 10%. To reach the same $750,000 in savings in just 20 years, you would need to save 25% of your income (ouch).

2. Have 10x your annual income in a nest egg.

Here again, this sounds like a reasonable goal. If you make $60,000 per year, this rule would say you need $600,000 in your nest egg at retirement. That sounds like a lot of money, but as our previous rule showed, accumulating over $600,000 is possible, even probable, if you start early.

Then again, maybe $600,000 is not that much money. Assuming you retire at age 65 and live until age 90, you’ll be retired for 25 years – a long time. If you earn 8% on that nest egg, you could withdraw $56,000 per year over your lifetime. That would be 93% of your annual income. If you have been saving 10% diligently and only need to replace 90% of your income, everything works out, right?

What you need to remember is inflation. $1 today is worth much more than $1 will be worth in 20 or 25 years. If we assume a steady 3% inflation rate, our initial withdrawal is only $43,000, or 72% of our income. Now you would have to rely on Social Security, a pension or other savings to reach your retirement goal.

A better goal would be 15x, or even 20x, which would ensure that you could take out a reasonable amount on an annual basis and allow for increases later on for inflation. As rules of thumb go, this is a poor one to follow.

3. Start retirement with no more than a 4% withdrawal rate.

Sustainable withdrawal rates are one of the most debated “rules” in all of finance. I have read numerous articles, white papers and investment policy statements that vary this number from 3% all the way up to 6%. All of them have worked over different periods of time and have the statistics to prove it. The question is what is a realistic number for most people over most time periods? What is the best rule of thumb?

For the answer, let’s look at what the different spending rates would mean in dollars and cents. Using our previous example of a $600,000 nest egg, a 4% initial withdrawal rate would provide $24,000 per year in income. Even a 5% withdrawal rate would still only provide $30,000, not nearly enough income for retirement. This shows the inherent weakness of the 10x savings goal.

Therefore, let’s say we have 15x, or $900,000 in a retirement nest egg. A 4% withdrawal rate would provide $36,000 of initial retirement income; closer to what we probably need, but still depending on Social Security and outside earnings or savings. In fact, to reach our $54,000 goal at 4%, we would need $1.35 Million, or 22.5x our ending salary! It would take 37 years to save this much at a constant $6,000 per year.

However, a 5% rate would provide $45,000 and a 6% withdrawal rate would produce $54,000. So why don’t you have a 5% or 6% withdrawal rate? If I earn 8% and withdraw 5% or 6%, everything works out fine. What could go wrong?

If you have to ask this question, then you haven’t been paying attention the last few years. While it is very possible for a portfolio to average 8% annually, performance varies on a year to year basis. Sometimes performance is much better than 8%, sometimes it is much worse. What your performance is in the early years of retirement has a significant impact on your future retirement needs.

For example, if we withdraw 6% per year from our $900,000 nest egg, and our first two years of performance are 10% and 6% (average of 8%), then we will have $938,000 in the account at the end of two years. However, if performance is -10% and then 26% (also an average of 8%), we would only have $898,000 in the account; a substantial difference.

This means that if you start retirement at the beginning of a bear market (i.e. 2000), your performance will negatively impact your savings, potentially causing a high initial withdraw rate to consume too much of your savings early on. This would lead to less growth and a lower standard of living later on in life.

Therefore, there needs to be some balance in the initial withdrawal rate, and flexibility as retirement progresses. A 4% withdrawal rate is probably too small for many retirees, and will not produce enough income to meet their standard of living needs. However, a 6% withdrawal rate could lead to problems down the road due to inflation or poor investment performance. A 5% withdrawal rate, along with the flexibility to change this slightly if necessary, is a better target to shoot for.

All told, the 10/10/4 rule of thumb turns out to be a weak guideline for retirement planning. It oversimplifies some key retirement issues and parts contradict other parts. While rules of thumb are good for some things, for a topic as complicated and changing as retirement planning, you are much better off having a detailed analysis and a plan that gives you lots of flexibility.

Michael Kalscheur, CFP®, is a Senior Financial Consultant at Castle Wealth Advisors, LLC. Castle specializes in helping families and closely-held business owners with strategies to protect and transition family assets from one generation to the next. Castle’s senior partners also work with clients throughout the country in making logical decisions to help them fulfill their personal and business financial goals. For more information visit, call 1-888-849-9559 or contact Michael directly at .