Rules of thumb: Do these popular retirement planning hacks measure up?

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.

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 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. High income earners may require less than 70%.

The Retirement Income Review 65–75% replacement rate

The government’s Retirement Income Review (RIR), which reported in July 2020, drew on research mentioned above by the Grattan Institute and others to recommend the use of target replacement rates to estimate retirement income needs. Rather than reduce the target to a single figure, the RIR suggested a replacement range of 65–75% would be appropriate for most Australians.

The RIR argued that replacement rates are preferable to the most common alternative in Australia – budget standards (see below) – because they provide income targets based on the income a person earned while they were working. This has the advantage of ensuring you continue your pre-retirement standard of living throughout your retirement years, with one very big caveat.

The RIR conceded that a target of 65–75% of pre-retirement income would not be enough to prevent poverty in retirement for Australians in the bottom 20% of income earners. For this group, the safety net of the Age Pension and other government supports will be necessary.

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 money, 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 were temporarily halved following the sharp fall in asset values due to the coronavirus. This was so that retirees were less likely to be forced to sell assets and lock in losses to meet their minimum pension requirements.

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 have a 90% chance they would 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 90% success rate.

For those who dream of early retirement, he found that a 3% withdrawal rate would give you a portfolio that would last 50 years.

This formula differs from Australia’s minimum pension drawdown rules, which are based on a percentage factor that increases as you age rather than adjusting for actual inflation rates.

Bengen based his 4% rule on actual returns over rolling 30-year periods between 1926 and 1992. 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.

Despite the Bengen Rule’s durability, concerns have been mounting that what held true in the past may be overly optimistic for today’s retirees when shares are near historic highs and bond yields near historic lows.

So Morningstar recently re-ran the numbers for Australian retirees. It’s State of Retirement Report in November 2021 found a safe initial withdrawal rate is lower today at 3.3% for balanced portfolios (using an expected inflation rate of 2.21%).

While 3.3% is below Australia’s minimum mandated withdrawal rates for super pensions, you’re not required to spend the money you withdraw. It could be invested outside super to continue compounding. The report’s authors also suggested strategies that would allow retirees to increase withdrawals by better aligning them with their personal spending needs. For example, not adjusting withdrawals for inflation or taking out less after a market fall and more after a market rise. You could also work a few years longer and continue contributing to super to reduce the rule’s 30-year time horizon.

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 drawdown 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. However, once they turn 85 they would be required under the current rules to withdraw more than the Rule of Thumb.

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 drawdown 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. Some, like Bengen’s 4% Rule, are based on overseas experience. 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.