4 Retirement Rules of Thumb Explained

Have you heard the one about how the financial mysteries of retirement can be solved with a couple easy-to-use calculations? Just save X% of your income or take X% out of your 401(k) each year and you'll be home free?

It would be great if these rules of thumb worked for every investor in every situation, but such guidelines aren't particularly nuanced. It also doesn't help that they're frequently misunderstood and applied incorrectly.

They're not all bad, of course, especially when used as a starting point. The trick is knowing their limitations and adjusting your plans accordingly.

Here, we look at some common rules of thumb and explain where they can go wrong.

The detail most people miss here is that a 10% to 15% savings rate—which includes any match from your employer—makes sense only if you start saving in your mid-20s or early 30s. If you start later, you’ll likely need to save more to maintain your current standard of living in retirement.

The table below can give you a more realistic sense of how much of your paycheck you should consider saving, depending on the age when you start. As you can see, the sooner you start, the less you generally have to set aside—thanks to the power of compounding. If you're older, the best approach is probably to save what you can and consider increasing that amount over time by pre-committing to saving any pay increases.

Investors who want to know if they're saving enough for retirement sometimes start with the idea that they need 25x their current gross income—that is, their earnings before taxes and other deductions. However, this is misleading because gross income includes retirement contributions that go away in retirement. Plus, most people start receiving Social Security benefits (or a pension).

There is a "25x rule" for retirement savings—but it should actually be applied to how much you think you'll need just from your portfolio in the first year of retirement. Determining that amount can be challenging if you haven’t worked on a financial plan with a professional (which is why we recommend that people take that step).

You can use your gross annual income to measure your savings–if you use a realistic multiplier. Keep in mind that targets listed below are aspirational. If they seem unachievable, the best remedy is to save what you can and work with professionals to develop a plan for getting where you want to go:

The 4% rule is frequently misunderstood to mean you should withdraw just 4% of your portfolio every year if you want it to last. Some take it to mean you should seek a 4% yield from stocks and bonds and live off that.

However, the rule actually suggests that you add up all your investments during your first year of retirement and withdraw 4% of that total. In subsequent years, you would adjust the resulting dollar amount you withdraw to account for inflation. By following this formula, you should have a very high probability of not outliving your money during a 30-year retirement.

The 4% rule is a good starting point for some retirees, but we think you can actually be more flexible than that. In fact, with the right allocation and planning, you may be able to withdraw more.

This one can be fine as a starting point for someone who has substantial assets and only needs to tap interest and dividends to fund their retirement.

Other investors may find they need—or want—more stocks in their portfolio. The idea here is to let your risk tolerance and risk capacity determine your allocation. Think of it this way: Risk tolerance is a state of mind that can fluctuate in response to the market. Risk capacity, on the other hand, is fixed: Your goals have an end date, and you either have time to bounce back from losses or you don't. Combining the two can help you plan your allocation.

The chart below offers some examples of how you could approach your allocation at different points in retirement. Again, these are just possibilities. Where you end up will depend on your preferences.

Rules of thumb gain currency because so many people cite them, but they are no substitute for a financial plan that you monitor and update regularly. Think of them as a starting point—and then personalize.