Meridian Blog

Rules of thumb, they exist for every facet of our lives and can be helpful as benchmarks.  But how accurate and applicable are they actually? Recently I read about the 5-2-1-0 rule of thumb for kids — 5 servings of fruits and vegetables a day, no more than 2 hours of screen time daily, at least 1 hour of physical activity, and 0 sugars.  While I am all for healthy lifestyles, the last rule gets me,  particularly during the summer.  Come on, who can say no to summer treats… and these faces!

Rules of thumb seem to be even more prevalent when it comes to personal finances, retirement planning, and financial planning. These can be great starting points, but these are “one size fits all” methods that do not incorporate the unique details around individual needs, wants, and goals.  The definition of a rule of thumb says it all – “A broadly accurate guide or principle, based on experience or practice rather than theory.”

Here are a few of the most discussed financial rules of thumb.

Savings Levels

One of the most, if not the #1, asked question when reviewing a client’s financial plan is, “How much should I have saved away to allow me to retire?”.  Unfortunately, my answer always is, “that depends”.  As demonstrated below, there are a couple of benchmarks out there that can provide a rough estimate of how much to save at various points in your life.

Keep in mind that all these projections are based off assumptions around retirement ages, lifespan, allocations, historic returns, market volatility, distribution rates, and projected Social Security benefits.  The reality is the chances of all those assumptions lining up perfectly with your individual situation is slim.  having a some guidelines in place provides motivation and way to take a pulse on current savings levels.

4% Rule

One of the most debated rules of retirement planning, the 4% distribution rule was published in 1994 by William Bengen who articulated that retirees could expect their portfolio to last for 30 years if they start out withdrawing 4% of their assets annually, increasing the distribution by inflation, and rebalancing annually.  There are a few issues with this “rule”.

• It was based on a portfolio comprised of a 50/50 allocation between just two asset classes, intermediate Treasury bonds and large-cap stocks.
  • Owning two asset classes is not a diverse portfolio and an allocation of 50% stocks and 50% bonds is not always the most appropriate allocation or in line with a client’s risk tolerance. This is also assuming that the allocation remains stagnant.
• The model is based off historical returns which may not apply over the next 30 + years.
• It assumes that cash flow needs remain constant throughout retirement and do not vary. Any retiree knows this is not always possible.

• It is based off a 30 year timeline which varies from person to person based off their retirement age and life expectancy.

Emergency fund – 3 – 6 months of living expenses

Building up savings to cover 3-6 months of living expenses is one of the first financial planning to-dos to as coverage for unexpected expenses or to cover cashflow if there are gaps in employment.  However, emergency savings levels may be more than 6 months of expenses if you are self-employed, plan on changing careers, are a single income household, or if you have a short-term expenditure such as a house project, purchase of car, vacation, etc.  The emergency savings should always be in a liquid and interest-bearing account such as savings or even a money market.  And while short-term interest and savings rates are higher than they have been in many years, anything in excess of the emergency savings should be invested for intermediate and long-term goals.

50/30/20 Budget Rule

This budgeting rule divides after-tax income into three categories – 50% on needs, 30% on wants, and 20% on savings.  While this method might be a way to think about how to carve off your income, it may not be realistic for individuals depending on income levels, housing costs, cost of living, dependent care costs, student loans, etc.  Also this rule suggest that you are putting 20% of  take home pay (i.e – taxes and deductions have already been taken out) into savings; however, it does not take into consideration pre-tax retirement contributions or adjust if an individual’s emergency savings bucket is already filled.

Rather, it is more useful to strive for contributing 15% of gross pay into savings (which can include employer contributions) and the rest should be carved off based on individual needs and goals.

Debt to Income ratio 28/36

The 28/ 36 rule is a practice standard stating that housing costs should not exceed 28% of gross income and total debt payments should not exceed 36% of gross income.  This rule is often applied to conventional loans and is essentially the golden standard for financial planning providing some parameters for those looking to either buy a home or borrow.  However, as housing costs have increased, it is getting more difficult to stay within the 28% debt to income ratio, particularly for first time home buyers.

100 minus age

This one really gets me.  The 100 minus age rule states that your recommended allocation to equities (stocks) can be found by subtracting your age from 100.  Based on this method, a 45 year old should have 55% of their portfolio invested in stocks and 45% in fixed income.  There are a few issues with this rule of thumb. It does not take into consideration individual risk tolerances, the effects of inflation on a portfolio, the amount of the investment, timelines, or sources of income, to name a few.  If we take a 45 year old for example, their retirement account is considered a long-term investment as there is roughly a 30 year timeframe before they are even required to start taking distributions. If the investor followed the 100 minus age rule in a long-term investment account, they would be limiting their returns based off historical performance of stocks versus bonds.    Rather a prudent allocation should be built around a combination of timelines, goals, risk tolerance, and risk capacity. These vary from investor to investor despite their age.

Again, Rules of Thumb can be a good base case for starting a financial plan, but a truly successful plan should allow for changes and be based on your unique circumstances.   Working with a trusted Advisor / Financial Planner to define savings goals, portfolio allocations, and large financial decisions creates a more customized approach that is individualized rather than an out-of-the box “broadly accurate” method.