Everything You Think You Know About Retirement Is Probably Wrong

Retirement is a major source of worry for the majority of Americans, 63% of whom fear running out of money during retirement more than they fear death.

Unfortunately, Americans are right to be concerned because most are saving far too little for retirement -- in part because of a lot of misinformation and outdated "rules." The good news is, by facing up to reality and making a concrete plan, you won't need to be scared any more.

Here's the truth about six of the big misconceptions you probably have about retirement.

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1. You should save 10% of your income

It's a commonly held belief you should save 10% of income for retirement. Unfortunately, if you believe this, you're probably not going to have enough money. This chart, using data on personal income from the U.S. Census, shows how much you'd have by 67 if you started saving 10% of your income in a 401(k) at different ages, with initial income based on the median for your age group in 2016, assuming 3% annual raises and 7% returns.

Calculations by author.

Since inflation means savings will be worth far less by age 67 -- and since $1 million already won't last long in many parts of the country -- you're in trouble if you save just 10% of your income. And, your financial problems may be worse than this chart suggests, as many experts don't believe 7% returns are realistic going forward.

Because of low interest rates, longer life spans, and the likelihood you're not saving 10% starting in your 20's, you'll need to save closer to 20%. If you start at 30, save 20% of income, and keep other parameters the same, you'd end up with a much more comfortable $1.84 million by 67.

Saving 20% of income can seem impossible. To do it, you'll need a spending plan that prioritizes savings. Making lifestyle changes, like driving a reliable used car instead of borrowing for new vehicles, could free up space in your budget to save.

2. You should retire at 65

Because 65 is the age Medicare becomes available, it's often viewed as an ideal age to retire. In fact, according to a 2015 Gallup Poll, 56% of Americans plan to retire at age 65 or before while just 37% of Americans expect to work past 65. Before you decide to retire at 65, make sure you have enough savings by estimating how long your savings must sustain you, how much you'll be able to withdraw annually, and what your spending will be in retirement. The earlier you retire, the longer your savings must last and the less time you have to save.

If you plan to take Social Security benefits as soon as you retire, understand the implications. Social Security benefits are calculated based on full retirement age (FRA), which is 67 if you born after 1960. If you retire before FRA, benefits are reduced by 5/9 of 1% for each of the first 36 months and an additional 5/12 of 1% for each additional month. When you retire early, your benefits reduction is permanent, unless you take steps such as rescinding your application within 12-months and paying back benefits. If you wait until after FRA, benefits are increased by 2/3 of 1% for each month you delay, up until 70.

There are times it makes sense to retire before FRA, as you can begin claiming Social Security as early as 62 -- but don't make the choice without understanding the impact. The chart below shows how retiring early or late changes the average Social Security benefit of $1,404 in 2018.

Calculations by author.

Do the necessary math to calculate when you'll break even if you delay in claiming benefits. To find this number, multiply your lower annual benefits by the extra years of benefits you'll receive and divide this by the difference between your higher and lower annual benefit. With this information, you can better choose your retirement age.

3. Social Security can support you

More than one third of all Americans expect Social Security to be a major source of retirement income, according to Gallup. Unfortunately, trying to live on Social Security benefits is a recipe for financial disaster. If you received the average $1,404 benefit in 2018, you'd have an annual income of just $16,848; barely above the federal poverty level.

Seniors have high healthcare expenditures, with mean expenditures of $5,994 in 2016, according to the Bureau of Labor Statistics. Record numbers of seniors are going into retirement with mortgages, student loans, and other outstanding debt. If you're struggling to live on Social Security, you'll have a hard time meeting basic expenses and a single unexpected expense could cause financial devastation.

Because it's so hard to live on Social Security, don't try. Save and invest with the right investment mix to earn a reasonable rate of return -- subtract your age from 110 to find the percent of income to invest in stocks -- and avoid high fees that eat into returns.

4. Medicare will pay for your healthcare needs

Many seniors look forward to Medicare because they think it will cover healthcare needs. Unfortunately, there's a lot Medicare won't pay for, including dental care, hearing aids, eye glasses, and nursing home care. Prescriptions may also cost more than expected. In fact, new data from Employee Benefit Research Institute found a senior couple with Medigap will need almost $370,000 to have a 90% chance of covering medical costs if they're in the 90th percentile for prescription use -- and this doesn't count costs of nursing home care.

A health savings account allows you to invest with pre-tax money and make tax-free withdrawals to pay for care costs, if you have a high deductible heath plan and are eligible to invest. If you can't contribute to a HSA, make another plan, such as putting extra money into an IRA for healthcare.

5. You'll spend less in retirement

Most people believe spending will decline in retirement, but this isn't what happens for many seniors. In fact, according to research from the Employee Benefit Research Institute, around half of all households across all income levels increase spending in the first two years of retirement, with close to a third exceeding pre-retirement spending by 120%. Around a third of households continue higher spending for at least six years after retirement, with 23% spending at least 120% more.

Retirement spending tends to be higher during early retirement when retirees are active and drops during the middle phase of retirement before rising again when health expenditures increase during late retirement. The money may run out right when it is most needed for vital healthcare expenditures. To avoid this, set a realistic goal for how much money you'll need during retirement. Instead of anticipating you'll need to replace 80% of income, aim to replace at least 100%.

6. You can withdraw 4% annually from your savings

Many people use the 4% rule to estimate how much to take out of retirement savings. This "rule" stipulates you can withdraw 4% annually without running out of money. Unfortunately, following the 4% rule doesn't make sense any more for the same reason other "facts" about retirement have become myths: life expectancies and expectations for returns have changed.

According to a 2013 study by the American College and Morningstar, following the 4% rule would give you around a 57% chance of running out of money, based on returns calculated at the time of the study. Instead of the 4% rule, use life expectancy tables to estimate how much you can safely withdraw each year or air on the side of caution by withdrawing a lower percent -- ideally around 2.5% to 3%.

Don't let your misconceptions hurt your retirement savings

With so much misinformation circulating about retirement, it's no wonder eight in 10 Americans are confused about how much money they'll actually need to retire.

Now that you know the reality, you can make an informed plan so you won't have to worry about running out of money too soon.

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