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Financial Rules of Thumb: Harm or Help?

I come across a lot of averages and rules of thumb in the financial planning profession.  While they can be helpful at times, they can also be dangerously wrong.  As a non-financial example, the average depth of the Chesapeake Bay is 21 feet.  That’s interesting information, but hardly useful if you are going to navigate a large vessel through its waters.  Much more needs to be known for safe passage.  The same is true with financial matters.  Nonetheless, some rules of thumb can be useful as a starting point or “sanity check” with how you’re doing.  Here are a few that I come across consistently, along with my two cents on accuracy and other factors to consider.

Home Purchase. The value of your residence should not exceed two and half times your annual income. For example, if your household income is $100,000 per year the maximum home value should be $250,000.  Note, I am assuming you put down 20%, which then makes the rule accomplish at least three things:

  • You avoid Private Mortgage Insurance (PMI)
  • You have a good equity buffer in your home
  • You have kept your principal/interest/taxes/insurance payment to about 15% of income. This is a very comfortable margin, allowing plenty of room for other living expenses (including the never-ending home maintenance) and savings.

Lower borrowing costs will make this rule easier to follow or easier to fudge on, depending on how you look at it.  Also, you will want to consider the stability of your income before committing… paying the monthly mortgage is not a discretionary expense.

This rule probably doesn’t work in very high-cost locations.

Portfolio Allocation. The percentage of your portfolio that should be in risky assets vs. more conservative assets is 120 minus your age. In other words, a 20-year-old would typically have 100% in stocks, while a 60-year-old would have 60% in stocks.  I think this rule is totally wrong and should be banned.

The real determinants of how much in what type of assets should be based on:

Risk Tolerance – how do you feel about risk, and more importantly, how are you likely to behave when things go badly

Risk Required – how much risk to you need to take to fund your goals

Risk Capacity – how much risk can you afford to take

The first can be measured with a valid risk profiling questionnaire.  The other two can be answered in a financial plan. Nothing else matters if you don’t get this right.

Downside Risk. In a normal bear market, the risky portion of the portfolio (stocks, etc.) will typically lose half its value. So, your all-stock investor portfolio would decline by half. Your 60% stock portfolio would see a decline of about 30%.

 Savings Rate. The traditional rule of thumb is that annual retirement savings should be 10% of your income. In my opinion this is correct for people who are young and just getting started.  If you are getting a late start, a higher percentage will probably be required.

Other variables that will affect this are:

  • Higher portfolio risk/return will require less saving and vice versa
  • Higher income households can and should save more, with a cap in the 20-25% range

Income Rule.  You will need to save 20 times your final gross income.  Think of this as a backup rule of thumb to the Savings Rate rule above.  This rule is partially based on the rule that you will need about 80% of your final income in retirement and the Spending Rate rule below.  Example:  Final pay = $100,000, accumulated value = $2,000,000 x 4% = $80,000.

The obvious problem with this rule is that unless you are fairly close to retirement, you don’t really know what your final income will be.  Also, your standard of living during your working years may be different compared to retirement.

Spending Rate. The traditional rule of thumb is that retirement spending should be no more than 4% of initial portfolio value (and then adjusted annually for inflation). This is roughly correct at the beginning of retirement.  As you progress through the retirement years, the percentage that can be taken increases (somewhat similar to what happens with IRA required minimum distributions).

One big variable to consider with the 4% rule is how much savings will be accumulated in tax-deferred versus tax-free versus taxable accounts.  As an extreme example, there will be a noticeable difference in the spendable (i.e. after-tax) dollars in distributions from a $1,000,000 Roth IRA versus a $1,000,000 Traditional IRA.  At 4%, each would produce an initial annual distribution of $40,000.  The Roth would be tax-free and therefore able to meet a $40,000 spending goal.  The Traditional would be taxable income.  So, if your marginal tax bracket is 25%, the after-tax amount would only be $30,000.  Since multiple buckets can be used for accumulation, this gets a bit complex and is why more detailed planning is needed during the accumulation and withdrawal phases.

Another large omission in the above rules is the amount of income that will be provided by a pension, social security, inheritance or other sources that are specific to your situation.  All of these variables are why it’s important to align all of this information in a comprehensive financial plan.

Any information presented here is general in nature, believed to be reliable as of the date published and is not intended to be and should not be taken as legal, tax, investment or individual financial planning advice. Competent, licensed professionals should be consulted when implementing any kind of financial, estate, tax or investment strategy.

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