I’ve taken a look at several retirement rules of thumb on The Blog, including the 3% rule, the 4% drawdown, and the bond-to-equity allocation ratio, and found that they may not necessarily be good ideas. Today I’m going to take a look at the 80% rule, which suggests that pre-retirees create a savings plan that will replace 80% of their income when they retire.
Let’s begin with a thought experiment: Imagine if you knew exactly how long you were going to live, when you were going to retire and how much you were going to make during your career. In such a highly certain world, odds are your retirement savings strategy would be pretty straightforward.
To illustrate one approach, the chart below assumes a twenty year lifespan, with retirement after ten years and a salary of $2.00 per year. It also assumes there is no inflation and no opportunity to earn an investment return.
In this example, we would save $1 of our $2 salary every year, leaving $1 to spend. Our wealth would accumulate steadily for ten years and peak at retirement. That would leave us with $1 to spend per year over the remaining ten years of the lifecycle.
On the simplest level, this thought experiment clearly illustrates that retirement spending is simply spending deferred. Spending more than $1 per year during our career would directly reduce spending in retirement. More subtly, it clarifies the true goal of retirement saving: maintaining a consistent standard of living.
By saving a dollar and spending a dollar, the blue bars – the spending level – remain consistent throughout the lifecycle. But what if our saving behavior was driven by a rule of thumb unrelated to our income and spending level? The next chart shows what happens if we were to apply our experiment to the 80% rule.