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There are many rules of thumb that guide people in managing their affairs, and investing is no different. The financial planning field is full of formulas for figuring out how to save for retirement, how to invest for retirement, and even how to spend in retirement. Here are three of the most popular: the 120-minus-your-age rule, the rule of 72, and the 4% rule.

The 120-Minus-Your-Age Rule

Asset allocation—deciding how your portfolio will be divvied up—is an important part of saving for retirement. Typically, an investment portfolio is divided between stocks and bonds (that is, growth and income). But how, exactly, to allocate? The traditional rule has been to take your age and subtract it from 100; the resulting number is the percentage of your portfolio that should be invested in equities. The remainder goes into the debt instruments. So, for example, if we had a 30-year-old investor, 70% of his assets would be in stocks; 30% would be in bonds.

Nowadays, to account for longer lifespans, many financial planners have changed this rule slightly to make 120 the number to subtract age from. So, under that same scenario, our 30-year-old-investor would be invested 90% in stocks (120 – 30) and only 10% in bonds. Those who are more risk-adverse can revert back to 100.

Of course, you adjust these asset-allocation percentages as you age.

The Rule of 72

The Rule of 72 says that your money will double based on the annual rate of return that you earn, divided by 72. So, for example, if you have a mutual fund that earns 8% annually (the stock market’s average rate of return), you can expect that your fund holdings’ worth will double every nine years (72 ÷ 8).

This rule is a great quick guide that can help you figure out your opportunity cost for different investments. Would your money do better invested in a rental real estate that doubles in value approximately every 20 years, or would your money be better invested in a certificate of deposit earning 3%? The rule of 72 will help you make those kinds of quick calculations and decide.

So much for getting. Now, let’s look at spending.

The 4% Rule

The 4% rule states that in your first year of retirement you should withdraw up to 4% of your nest egg. In subsequent years, to maintain the same lifestyle, you should adjust that amount, increasing it along with the inflation rate. For example, if you retire with a nest egg of $2,000,000, you would withdraw $80,000 in your first year as a retiree. If inflation increased 2% during the year, the next year you would withdraw $81,600. Looking back at historical results, if you had retired and started employing the 4% rule, your chances of running out of money in your retirement portfolio were very slim, even if you lived 30+ years with no additional employment income coming in.

Does the 4% Rule Work?

Why 4%? The answer lies in two words: interest income.

As they age, investors typically shift their portfolios away from growth towards income  (see the 120-minus-your-age rule, above). By the time they retire, they generally have a large portion—if not the majority—of their portfolios in bonds or other income-oriented assets.

Those bonds kick out interest income that can range from 2% to 5% for most investments. So when you withdraw funds,  you are primarily getting income out of interest instead of principal. This minimizes the impact of your withdrawals on the core of the portfolio, allowing it to continue to grow over time.

Will the 4% Rule Always Work?

The 4% withdrawal rule, like any strategy, has to be taken with a grain of salt—and an eye toward market conditions.

If you are heavily weighted toward stocks when you retire, and the stock market nosedives 25%, your nest egg will experience a massive hit. You want to avoid withdrawing funds when you’ve recently lost money. If you can survive on less while your portfolio recovers, your money will last longer. Likewise, if your portfolio jumps 25% at the very beginning of your retirement, you could likely enjoy some extra income in the following years because you got an unexpected boost.

Another strategy might be to to start your withdrawals at the 4% mark, but adjust in subsequent years based not on inflation, but on your portfolio’s investment performance. In good years you can get away with taking a bigger payout and in bad years it makes sense to cut back.

When Not to Apply the 4% Rule

If you want to be able to enjoy your savings while you still can, it might make sense to have a different strategy—one in which you withdraw a larger percentage in the first 10 years of retirement before drastically ramping down your income in later years. There are no seniors more tragic than those who retire with a huge nest egg, but never go out and enjoy any of it for fear of running out of money before they die. Except, perhaps, those retirees who do run out of money before they die and spend the last few years of their lives destitute or totally dependent on family to support them. Retirement is a balance, and you must find yours.

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