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Financial rules of thumb can be helpful tools, crude formulas that offer guidance on everything from asset allocation, to life insurance coverage, to the ideal portfolio withdrawal rate.
Such rules are rarely sufficient as a basis for making informed money management decisions, lacking as they do any context around our debt, assets, and future goals. But they do help to simplify some rather complex financial concepts, which alone may impel investors and savers to take action.
“Although every client has a unique situation and specific needs, we find it is still helpful to remember some basic rules when maintaining their financial picture,” said Daniel Drabinski, managing director of business and estate planning for Bluecrest Financial Alliances in Dallas, Texas.
That said, some financial rules of thumb have greater application than others. And a few that were once revered as the favored yardstick (we’re looking at you “4 percent withdrawal rate”) have now been modified or rendered obsolete by new risks to financial security, including greater stock market volatility, rising interest rates, and longer life spans.
“In my experience, some of these rules provide a good baseline; but based on risk tolerance, time horizon, and individual circumstances, there may be reasons why a financial rule of thumb may not align perfectly with an individual investor’s circumstances,” said Brock Jolly, a partner with Veritas Financial in Tysons Corner, Virginia. “I’d advise consumers to attempt to understand all aspects of these rules — the pros and cons — and determine how they apply to their particular situation.”
With that, let’s put some of the most commonly cited financial rules of thumb under the microscope for a closer look. They are:
- The Rule of 72 for investments.
- 100 minus your age in asset allocation.
- 4 percent withdrawal rate in retirement.
- 5 to 10 times your income in life insurance coverage.
- Save 10 percent of your salary.
- Have 3 to 6 months of living expenses in an emergency fund.
The Rule of 72
The Rule of 72 remains a popular yardstick for estimating the length of time it will take an investment with a fixed annual interest rate to double in value. To arrive at the answer, you just divide 72 by the rate of return you expect to receive.
Thus, an investment that earns 5 percent annual interest would double in value in 14.4 years (72/5), while an investment earning 7 percent annually would take 10.2 years to double (72/7).
According to many financial professionals, the Rule of 72 still holds up for investments with the potential for compounded growth.
Research suggests that it is most accurate for calculations that use a roughly 8 percent rate of return, becoming less precise the further you get from 8 percent in either direction.1
Remember, of course, that the Rule of 72 is merely a guide. Your investment portfolio will almost certainly not provide consistent annual returns. It will fluctuate. You will also owe fees and taxes, which will eat into your actual returns.
100 minus your age
Take this one with a grain of salt.
The “100 minus your age” rule — which now sometimes uses 110 or even 120 to account for longer life spans — offers a suggested split for how you should allocate your investment portfolio across equity and fixed income assets. Per the rule, you simply subtract your age from 100 (or 110) to arrive at the percentage you should invest in equities (stocks), with the balance earmarked to fixed income (bonds).
The intent of this rule is sound, helping to illustrate the importance of maintaining a balanced portfolio while reducing your equity exposure as you approach retirement.
But many consider the rule to be too conservative. After all, a portfolio that consists of half stocks and half bonds at age 50 would not likely generate the kind of returns many retirement savers need to reach their financial goals. And after age 60, a portfolio that consists primarily of fixed income might barely keep pace with inflation, which could result in a loss of purchasing power.
The bigger issue with generic asset allocation advice, however, is that it may not be appropriate for a majority of investors, said Drabinski. Your ideal allocation is unique to you. It should reflect not just your age, but also your tolerance for risk and your need for investment returns.
A financial professional can help you create a portfolio mix that’s right for you. (Related: Fix your mix: Asset allocation)
“I personally do not like any rule of thumb that dictates a perceived correct portfolio breakdown between equities and bonds,” said Drabinski. “Given the volatility and reversal in interest rates we’ve had in bonds during the past couple of years, many retirees or those near retirement have taken significant market losses on their bond positions.”
4 percent withdrawal rate
This one goes back decades, and there are plenty in the financial community who argue it may be obsolete.
The “4 percent rule” suggests that retirees can potentially siphon off roughly 4 percent of their portfolio in the first year of retirement (and adjust annually for inflation) without running the risk of outliving their assets. (Learn more: How to determine your ideal retirement withdrawal rate)
Hypothetically, that ensures that a retiree earning at least 6 percent per year in their investment portfolio would only ever spend their interest, leaving their principal untouched — a surefire way in theory to preserve assets. According to the rule, that strategy also enables retirees to maintain purchasing power as it leaves room for cost-of-living adjustments due to inflation.
With longer life expectancies, however, some say a 2 percent or 3 percent withdrawal rate may be more appropriate for many retirees. An even lower withdrawal rate might be appropriate for those who retire early and need their savings to last longer.
“This is where rules can be misleading,” said Jolly. “The 4 percent rule was written by an advisor in the early 1990s — a time when interest rates were significantly higher than today and life expectancy during retirement was approximately 15 years for men and 20 years for women. Today, interest rates are rising but they are still historically low and people are living longer, so the 4 percent rule may no longer be a safe withdrawal rate.”
On the flip side, some contend that investors with a sizable nest egg, especially those with a cash cushion from which to dip during bear market declines, may be able to withdraw closer to 4.7 percent per year depending on when they retire and how well the markets perform in the early years of their retirement. (Related: Beware retirement’s overlooked risk: Sequence of returns)
The withdrawal rate that’s right for you will take into account your unique financial picture.
5 to 10 times your income in life insurance coverage
There are many iterations of this rule. Some say that your life insurance coverage should equal 10 to 12 times your annual gross income. Others suggest that 6 percent of your gross income is a better target, plus 1 percent more for each dependent.
But the most commonly cited rule of thumb suggests that a life insurance policy that covers 5 to 10 times your annual pretax salary may be enough to help protect your family if something should happen to you.
As a jumping-off point, these are all reasonable ranges. But determining how much coverage you may really need depends on your goals.
For example:
- Do you have student loans or a mortgage that you’d like to pay off if you should pass away prematurely?
- Would you want your life insurance benefit to cover the cost of your children’s education or your daughter’s wedding?
- Do you want term life coverage only until your children are out of college?
- Would the features of permanent life insurance — cash value and a guaranteed benefit to your loved ones no matter how long you may live — be useful?
“It really depends on individual circumstances,” said Jolly. “The key is to consider the true impact of the death of a family member — whether that is a breadwinner or not. Good financial planning is a balance of risk management and wealth management.” (Calculator: How much life insurance do I need?)
Save 10 percent of your salary
Conventional wisdom dictates that we should all sock away roughly 10 percent of our annual pretax income each year for future retirement expenses. That’s a good start, but for many retirees it won’t be enough. (Calculator: How much should I save for retirement?)
The amount of savings you really need may be far higher — or lower — depending on your target retirement age, your guaranteed sources of income (pensions, Social Security, annuities, trusts), your annual portfolio return rate, and your expenses.
If you started saving in your 30s, you may need to save 15 percent or even 20 percent of your income to make up for lost time. The percentage gets higher for each decade you delay.
On the other hand, if your house is paid off before you reach retirement or you started setting money aside with your first paycheck, you may be able to safely save a smaller percentage of your income. (Learn more: Why saving for retirement early is important)
You can help boost your retirement savings by maxing out your pretax retirement accounts, such as your 401(k) or IRA, and taking advantage of any employer match you may receive. You can also effectively give yourself a raise in retirement by choosing to delay (if you can afford to) Social Security benefits beyond your full retirement age. (Related: 4 simple ways to delay Social Security)
Emergency fund: 3 to 6 months of living expenses
Any amount you save to an emergency fund is better than nothing, but if you’re looking to create a cash cushion to sustain you in the event of an unexpected expense or bout with unemployment, many financial professionals say that you need at least 3 to 6 months’ worth of living expenses set aside in a liquid, interest-bearing account (think savings account or money market).
Without an emergency fund, you may be forced to rely on high-interest credit cards, drain your 401(k), or take out a loan to provide for a sudden financial need. That not only creates a cycle of debt dependency, but can also negatively affect your long-term financial security.
If you are self-employed, a single-income household, or your job security is in doubt, you may need 12 to 18 months’ worth of living expenses set aside. (Related: Don’t have an emergency fund? Get one)
Make no mistake — retirees also need an emergency fund.
“One cannot stress enough the significance of having an emergency savings account, in addition to a non-market-correlated pool of assets, as they approach retirement,” said Drabinski. “The two biggest risks to a comfortable retirement are a significant market sell-off in the first five years of retirement and a health emergency.”
Retirees, he said, can at least “partially mitigate the effects of these risks by maintaining a volatility buffer that is inflation protected, liquid, tax free, and noncorrelated to the equity markets.”
Conclusion
Financial rules of thumb are best viewed as crude tools for measuring our financial health, but they are no substitute for tailored financial planning.
By working closely with a financial professional, you can create a financial road map that factors in your known variables and objectives, which may potentially position you to reach your goals faster.
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