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Short of having a degree in actuarial studies or a crystal ball, most of us settle for guestimates. That’s where Rules of Thumb come in.
Rules of Thumb, or heuristics if you want to get technical, are popular short-cuts based on practical experience. They won’t be 100% accurate in all cases but they offer a close approximation of what tends to work best in most situations.
These days Rules of Thumb used in financial planning are often based on computer modelling using historic averages, demographics and other statistics. They can be useful planning tools in the absence of detailed information, but they are no substitute for a personalised financial plan.
We’ve collected some popular Rules of Thumb used in retirement planning, their origins, usefulness and limitations.
The 70% target replacement rate for retirement income
It can be difficult to know exactly how much income you will need in retirement. But assuming most people will hope to continue the same standard of living they have come to enjoy, it makes sense to use pre-retirement income as a starting point.
A target replacement rate of around 70% of your pre-retirement income (after tax and super contributions) is recommended by the OECD, the Melbourne Mercer Global Pension Index, the Grattan Institute and the 2013 Cooper Review among others. The current Federal Government has not nominated a benchmark.
In a 2018 report, the Grattan Institute said it used a 70% target on the basis that most retirees own their home in retirement, no longer incur expenses related to work and substitute eating out for more eating at home. Retirees who rent will need to replace a higher share of their pre-retirement income in order to cover their higher housing costs through retirement.
The 70% target includes the Age Pension and super but not non-super savings.
The Grattan report found that low income earners entitled to receive a full Age Pension could expect a replacement income significantly higher than 70% of their pre-retirement income. While high income earners may require less than 70%.
Learn more in the SuperGuide article Target retirement income: An explanation of the 66–80% Rule of Thumb.
The 10/30/60 Rule
Superannuation is commonly viewed as a bucket of money you fill up while working; on the day you retire, you turn on a tap and gradually drain the bucket until empty. No wonder retirees often withdraw the minimum amount required under the pension drawdown rules (see below) in case their money runs out too soon.
What people often overlook when planning their retirement income is that the investments supporting your super pension continue to grow in value throughout retirement.
That’s where the 10/30/60 Rule comes in. This Rule of Thumb highlights the fact that not only does our nest egg keep growing after we retire, but around 60% of our super pension income is likely to come from investment earnings after we retire.
This is the typical breakdown of where your retirement income comes from:
- 10% comes from money you saved while you were working
- 30% comes from investment returns on your savings before you retire
- 60% comes from investment returns after you retire.
The actual investment returns over your lifetime will depend on your appetite for risk and the mix of assets you invest in. However, the 10/30/60 Rule highlights the importance of maintaining a mix of investments in retirement that will generate returns that are sufficient to support your income needs.
Minimum pension drawdown rules
When you retire and start an account-based pension with your super, you are required to withdraw a minimum amount each year depending on your age. This amount is expressed as a percentage of your account balance as at 30 June the previous financial year.
Normally the minimum drawdown percentage factor begins at 4% if you are aged under 65 and rises gradually to 14% when you are 95 or older (see table below). These government-mandated rates are a Rule of Thumb based on advice from the Australian Government Actuary. It determined that most people would spend most of their super at these rates, without leaving too much to the kids.
However, the normal rates have been temporarily halved following the sharp fall in asset values due to the coronavirus. This is so that retirees are less likely to be forced to sell assets and lock in losses to meet their minimum pension requirements.
| Age of beneficiary | Temporary percentage factor (2019/20 and 2020/21) |
Normal percentage factor (2013/14 to 2018/19) |
|---|---|---|
| Under 65 | 2% | 4% |
| 65–74 | 2.5% | 5% |
| 75–79 | 3% | 6% |
| 80–84 | 3.5% | 7% |
| 85–89 | 4.5% | 9% |
| 90–94 | 5.5% | 11% |
| 95 or more | 7% | 14% |
Source: SIS Act
Bengen’s 4% Rule
When it comes to Rules of Thumb to help retirees work out how much income they can safely withdraw from their retirement savings each year, all roads lead to Bengen’s 4% Rule.
William Bengen was a Californian financial planner. In 1994 he worked out that the average American retiree could withdraw up to 4% of their nest egg in their first year of retirement then adjust that amount for inflation in subsequent years and not run out of money for at least 30 years. So someone who retires at 65 could expect their money to last until they turn 95 with a high degree of probability.
This formula differs from Australia’s minimum pension drawdown rules, which are based on a percentage factor that increases as you age.
Bengen based his 4% rule on actual returns over 75 years. He argued that 4% would hold for an asset allocation of 50–75% shares with the remainder in bonds, but a portfolio with closer to 75% shares had a higher probability of lasting longer.
Spend your age
One of the criticisms of our minimum pension drawdown rules is that many retirees treat them as maximums, due to a fear of running out of money and a reluctance to seek financial advice.
A group of Australian actuaries decided there must be a better way to estimate how much retirees can safely withdraw each year; an amount not so great you risk running out of money and not so small you live more frugally than you need to. It also had to be simple and easy to communicate.
The result was a Rule of Thumb based on your age and assets they called Spend Your Age. Here’s what the group from the Actuaries Institute found:
- A single retiree should draw down a percentage that is the first digit of their age, for example, if you are 72 you withdraw 7% of your account-based pension
- Add 2% if your account balance is between $250,000 and $500,000.
The above rule is subject to meeting the statutory minimum drawdown rule.
As you can see from the table below, a person following the actuaries Rule of Thumb would withdraw more money than the statutory minimum up until age 84, but once they turn 85 they would be required under the current rules to withdraw more than the Rule of Thumb.
Note: The rates listed below are the normal minimum pension payment rates, rather than the temporary reduced rates applicable for the 2019/20 and 2020/21 years due to the coronavirus crisis. Learn more about the minimum pension payment rules (including calculator).
| Age | Minimum withdrawal rate | Rule of Thumb |
|---|---|---|
| Under 65 | 4% | – |
| 65–74 | 5% | 6% (7% from age 70) |
| 75–79 | 6% | 7% |
| 80–84 | 7% | 8% |
| 85–89 | 9% | – |
| 90–94 | 11% | – |
| 95+ | 14% | – |
While the working group looked at various rules of thumb used by retirees and their advisers, such as Bengen’s 4% Rule, none are designed specifically for Australian conditions and the complex interaction with the Age Pension.
By spending their age, many retirees could draw down more income each year and enjoy more Age Pension over their lifetime.
The bottom line
Rules of Thumb such as the 10/30/60 Rule, the 70% replacement rate, minimum pension drawdowns, Bengen’s 4% Rule and Spend Your Age are handy tools in the absence of detailed information. But they do have limits.
For starters, they are based on population averages and you’re not average. Also, they are based on historic returns, so they won’t tell you with any certainty how the future will unfold. For these reasons, while Rules of Thumb are a good starting point, they are no substitute for retirement income planning based on your personal circumstances.