Retirement rules of thumb are all about trying to help you determine a sensible rate of withdrawal from your account, as well as helping you figure out how much money you need to set aside now so that you can enjoy a successful and comfortable retirement later.
While the 4% rule has become a standard quick calculation for retirement planning, there is a new rule that is similar: The Rule of 20. A recent Money Talk on BNN featured Irshaad Ahmad, President & Managing Director of Russell Investments Canada, on the show to discuss this new calculation.
What is The Rule of 20?
The Rule of 20 states that for every $1 of retirement income you want, you will need $20 saved in your retirement portfolio. At first glance, I thought this might just be a “5% rule”. The extra percentage point is likely due to the fact that this rule already accounts for inflation, where the 4% rule only addresses the first year, and then adjusts each year for inflation. Also, The Rule of 20 states that you only need $20 in savings for every $1 of annual retirement income; no where does it say you should withdraw 5% each year. So the end result is likely similar to the results you see with the 4% figure. It's just as a simpler calculation for determining your retirement needs.
Something to Keep in Mind with The Rule of 20
Just as with the 4% rule, one key thing to keep in mind is that CPP and OAS will cover a substantial portion of most Canadians' retirement income. So if your goal is a annual retirement income of $50,000 for you and your spouse, the CPP and OAS payments will get you half way there since you can expect $25,000 for the average retired couple.
Since you have CPP and OAS to help you out, the amount that you actually have to base your retirement savings on (in our scenario) is $25,000 per year. Using The Rule of 20, you calculate that you will need a retirement portfolio of $500,000 in order to retire comfortably.
This amount is hard to compare to the 4% rule calculation since the portfolio has to be larger to allow the same dollar amount to be withdrawn. Let's look at the comparison another way. Using the 4% rule for $500,000 in savings, you would withdraw only $20,000 in the first year and then increase for inflation each year going forward.
This means that, with the 4% rule, you are withdrawing $5,000 less the first year. By the time you add the $25,000 for OAS and CPP to the $20,000, you only end up with $45,000 a year in income. You either need to adjust your withdrawal, or become used to the idea of dipping into your capital more than you had expected.
How Should You Calculate Your Retirement Planning?
Whichever calculation you decide to use, remember that it is just a quick method to plan your retirement. Neither rule can properly account for market volatility or personal factors such as your plans for travel or leaving an estate to your loved ones.
With retirement planning, it makes sense to thoroughly consider your options, and make your plans accordingly. Rules of thumb can help you, but you shouldn't become a slave to them.