Dubai: Planning for retirement can sometimes feel daunting, but there are ways to temper these worries.
Over the years, financial experts have come up with several useful rules of thumb that can help you get your finances organised. To be sure, there is no one-size-fits-all approach to retirement savings, but these strategies are a great place to start.
1. The 50/30/20 rule:
What is considered as the golden nugget of financial planning by most experts is the 50/30/20 rule, which suggests that you split your budget into three buckets:
• 50 per cent to pay for must-haves, including rent or mortgage payments, groceries, and minimum debt payments;
• 30 per cent to cover non-essentials, such as going to the movies or on vacation; and
• 20 per cent to save for retirement, build an emergency fund, and make additional debt payments.
The 50/30/20 rule has become very popular because it strikes a balance between wants and needs, and provides a simple approach to setting your monthly budget.
Assuming a monthly salary of Dh5,000, you would allocate Dh2,500 (Dh5,000 x 50 per cent) to needs, Dh1,500 (Dh5,000 x 30 per cent) to wants, and Dh1,000 (Dh5,000 x 20 per cent) to debt and/or your retirement fund.
2. At least 10 per cent of your income into retirement savings
There’s another rule of thumb for how much of your income should go specifically toward retirement. According to many financial advisers, you should contribute at least 10 per cent of your salary to your retirement fund or workplace savings plan.
Why is 10 per cent a rule of thumb? One possible explanation is the ease of calculation: Just take out a zero. With a gross monthly salary of Dh5,000, you know that you have to contribute Dh500 to your retirement account.
A caveat here is that you should be doing this for as long as you are working, starting as soon as possible. Young retirement savers will benefit the most because of compounding interest.
The more that you contribute to your retirement account in your early working years, the more time the funds will have to grow.
3. The 90/10 rule from Warren Buffett
In 2013, legendary investor Warren Buffett revealed that he ordered the trustee of his estate to allocate 90 per cent of his cash to a very low-cost index fund, and the remaining 10 per cent to short-term government bonds.
As the name implies, index funds simply aim to generate a return equal to the index they’re tracking, such as the key benchmark S&P 500 in the US, after fees.
Warren Buffett’s advice didn’t go unnoticed by investors. Between 2011 and 2016, investors took $5.6 billion (Dh20.57 billion) out of actively managed funds, which attempt to beat the market, and dumped $1.7 trillion (Dh6.24 trillion) into passively managed funds, such as index funds.
Putting 90 per cent of your retirement savings in a low-cost index fund greatly minimises your investment costs, since the expense ratios (the annual fees charged to shareholders) are much less than for actively managed funds.
This means more money is left in your account to grow, and therefore you increase your chance of hitting your savings target. Here’s an example.
Some equity index funds have annual expense ratios as low as 0.05 per cent, and those tracking the above mentioned key S&P 500 index had an average annual return of 8.65 per cent over the 2007–2016 period.
As you get closer to retirement age, you may want to consult with a financial professional on how to adjust your portfolio allocation according to your changing needs.
4. The popular four per cent rule
After testing a variety of retirement withdrawal rates using historical rates of return, several financial planners determined that four per cent was the highest rate that held up over a period of at least 30 years.
Here’s how it works: Assuming a Dh600,000 nest egg, you would withdraw Dh24,000 in your first year of retirement. In the second year, you would withdraw the same amount plus extra to cover inflation.
Assuming an annual rate of inflation of 2.5 per cent, your second and third withdrawals would be Dh24,600 and Dh25,215, respectively.
While the 4 per cent rule is not without critics, nor is it the perfect calculation for everyone, it continues to help retirees plan ahead the size of their withdrawals during their retirement years.
Some years you may have to withdraw a bit extra beyond your planned four per cent, financial planners also caution.
These four rules of thumb can give you a leg up on your retirement strategy. However, think of them more as guidelines and not so much as commandments.
Every financial situation is different, so make the most of the available information and resources through your employer-sponsored retirement plan. Consult a financial adviser whenever necessary.