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A Report Card for Financial Rules of Thumb

This article was written by in Personal Finance. 49 comments.


I’m not a big fan of “rules of thumb.” These are bite-sized nuggets of wisdom masquerading as advice, designed to apply to a mass audience. At best, they cant point someone in the right direction, but at worst, rules of thumb can erroneously send people on the wrong path or can mistakenly instill a false sense of security. This is a good example of why the best financial advice is specifically tailored to an individual or a family.

Rules of thumb satisfy the human desire for knowledge on a stick, like fast food for the brain. They are easily repeatable and retweetable, and they invite a minimum of critical thinking. But it would be unfair to suggest ignoring all rules of thumb. Some are better — more accurate for a larger number of people — than others. But it’s important to determine which ones apply to your situation and which one’s are not relevant.

Here are some of the more popular rules of thumb targeting personal finances, often repeated by gurus and writers targeting a wide audience.

Rules of thumb

You should save 10 percent of your income. Grade: B-.

This rule of thumb is not specific. It is not clear whether 10 percent should be counted before or after taxes. Saving this percentage of your gross income, a larger sum than the same percentage of your “take-home” income, would be preferred. This rules of thumb also does not specify whether your 401(k) or other investments are included or if this only refers to savings not invested or spent.

I can’t say that saving 10 percent is a bad idea. This is a good starting point; in fact, putting this portion of your income away without touching it will put you far ahead of the “average” American. Many people, however, will need to save more, some significantly more, than 10 percent in order to meet their goals. This rule of thumb, ingrained in the minds of many people who have read books suggesting this amount, can convince someone than 10 percent is enough.

Your emergency fund should be large enough to replace 3 to 6 months of your income. Grade: D.

Again, this is a good starting point, but your income is not related to the size. Your emergency fund should be allow you to afford your non-discretionary expenses while you work to replace your income. Determining the right size for your emergency fund requires measuring your monthly expenses, judging the stability of your income, determining what you would be willing to do to replace that income, considering how much it might cost to relocate in an emergency, and seeking expenses to cut.

The economy and the job market — how long it might take you to find a new job — should be a consideration as well. A better rule of thumb might state that the size of your emergency fund should be enough to cover necessary expenses for the number of months equal to the unemployment rate. For example, if the unemployment rate in your state is 10 percent, your emergency fund should be large enough to cover 10 months’ worth of expenses.

You can withdraw 4 percent of your nest egg in retirement to provide yourself an income while keeping enough invested to last indefinitely. Grade: C.

The 4 percent “safe withdrawal rate” relies on a number of dangerous assumptions. First, the funds from which you take the 4 percent must be invested completely in a diversified selection of stocks, like the S&P 500. As we’ve seen recently, beginning retirement while completely invested in stocks in a year where the stock market is down can be disastrous to financial health. Secondly, in assumes the stock market will perform 5 percentage points higher than inflation. That’s a reasonably good estimate when you look at the stock market on average, but there is rarely an average year. The stock market performs significantly better in some years and significantly worse in others.

The rule of thumb is not detailed enough to explain, but 4 percent is the withdrawal rate for the first year only. The withdrawal in every subsequent year should increase by the rate of inflation. For example, if you withdraw $40,000 from your $1,000,000 in the first year, and in the second year your nest egg increases to $1,001,000 after a year where inflation was 3%, your withdrawal in the second year should be $41,200 (3% more than $40,000) rather than $40,040 (4% of your new balance).

To find the percentage of your portfolio that should be invested in stocks, subtract your age from 100. Grade: F.

According to this rule, once you are no longer a minor the most you’ll be invested in stocks or stock mutual funds is about 80 percent. Someone retiring at age 65 would have a portfolio only 35 percent invested in the stock market. This directly contradicts what would be necessary to make the 4 percent safe withdrawal rule of thumb a reality. And for most people, the calculation using 100 just simply won’t cut it in order to grow wealth over the long term.

There’s more to consider. Suze Orman has a massive net worth compared to most people, and can therefore afford to play it safe by investing almost all of it in bonds. Stocks are riskier, and she and other people with significant net worth do not have to take on as much risk as what is found in the stock market to provide more than enough income for the rest of their life. Not only that, but significant wealth in a less risky investment helps ensure there will be an estate to leave to family or charity at the end of life.

The rest of us must take on the risk of the stock market in order to provide the best chance of building wealth in the long term. And the amount of risk needed for us is a higher percentage than the result of subtracting your age from 100. Perhaps 130 or 140 would be a better figure to use.

To retire comfortably, you will need to have an income of 80 percent of your maximum pre-retirement income. Grade: C.

Although it’s common to believe your needs, and therefore expenses, will be less in retirement, reality shows that this is not always the case. It is safer to assume that your expenses will be 10 percent higher in retirement. Keep in mind that health care costs will most likely rise dramatically as you age. And with people living longer than ever, those expenses will last for many years.

Once size does not fit all. Rules of thumb are good starting points, but don’t fall into the trap of believing you are safe if you follow these rules. Do you know of any other rules of thumb deserving a thrashing?

Photo: John Leach

Published or updated September 22, 2009. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @ConsumerismComm on Twitter and visit our Facebook page for more updates.

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About the author

Luke Landes is the founder of Consumerism Commentary. He has been blogging and writing for the internet since 1995 and has been building online communities since 1991. Find out more about Luke Landes and follow him on Twitter. View all articles by .

{ 21 comments… read them below or add one }

avatar Mike Piper

Hah. I wrote about this very topic today as well. Though my opinions almost directly contrast yours.

I think the “age in bonds” rule is great. It only needs to be adjusted for one variable–volatility tolerance.

I think the “save 10% of your income” rule is awful, frankly. It doesn’t account for any of a whole list of variables that factor into the decision (how old you are when you start saving, when you plan to retire, whether you own your home, etc.).

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avatar Steve

Do you have a replacement for the “4 percent” rule? You say it’s bad but not what would be better.

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avatar Luke Landes ♦127,535 (Platinum)

Steve: Replacing one rule of thumb with another is not always a good decision. I could say stick to withdrawing only 1% of yoour stock portfolio for your first year of income in retirement, and that could still fail. If your goal is to pass your wealth onto progeny and/or charity, the best rule of thumb is to die while you still have your assets rather than living long enough to drain them.

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avatar Steve

I don’t disagree – the point you are trying to make (if I understand it) is that rules of thumb are generally to broad and simplistic. (And that’s just the ones that aren’t blatantly incorrect!) However there must be some other formula or set of considerations or something along those lines to fill in the void. Sooner or later you have to use some method to decide how much money to withdraw.

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avatar Mike

With all due respect – withdrawing 1% in the first year is ridiculous. If you are that uncertain about the safe withdrawal rates and want to be ultra-conservative then don’t retire – that’s the safest method.

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avatar Luke Landes ♦127,535 (Platinum)

You’re right, for most people 1% would simply be insufficient. But there’s also little need to withdraw more than you need, so if you need less than 4% you can provide yourself a better chance of weathering the market and letting your nest egg last longer.

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avatar SteveDH

80% of your max pre-retirement income…Grade F. !00%-125% of your pre-retirement SPENDING and expenses… Grade A. I retired in December of 2007 and the only “spending” that decreased was that stinking tank of gas I put in my car every week to get back and forth to work. Other spending either remained the same or increased slightly. Expenses such as taxes go down (SocSec & Medicare taxes disappear) and what about all that retirement saving done prior to retirement – no need now. My wife and I have maintained our lifestyle, cruised to Hawaii, and even saved a tad on 48% of our pre-retirement income. The statistical population used for the 80% rule is skewed by many who have done little to prepare for their retirement – either by choice or circumstance. Start your retirement plan with a foundation based on what you are spending, not what you’re earning.

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avatar Doctor S

Agree with the notion on the emergency fund being a 3 to 6 month repository of sufficient funds to pay off expenses in that much time. I think an emergency fund should be as big as you feel you need. You have to think that if you did lose your job, you would cut back on expenses. When I think of emergencies though, I think of medical bills, helping out family, and more medical bills. In this society where we have no idea where our financial markets and healthcare industries are going, it may be smart to have even a years worth sitting aside ni thsi so called “Emergency Fund”.

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avatar Eric J. Nisall

“One size does not fit all” sums it up PERFECTLY. Actually, that’s also the title of a post I did a while ago on a similar subject. No “rule” can be applied to everyone in general, and attempting to make a blanket statement regarding anything, especially finances is irresponsible.

Personally, I think all rules should be trashed, and each person/couple shoud do what is best for them, regardless of what the “popular” opinion is. No one can truly know how you think or feel about mone., The best advice I can give to clients and anyone who asks is to look within themselves, and be brutally honest with themselves. If you can’t be honest with yourself, then no amount of advice or “rules” are going to make a difference.

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avatar RJ Weiss

Rules of thumb are great for some and horrible for others. The most important thing to do is understand the concept behind the rule.

I do have to disagree on your age in bonds. I would at least give it a C. It’s a great starting point for someone who knows little about investing.

Someone more educated would be able to increase their percentage in stocks because there behavior risk would decrease.

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avatar Greg

Eric said it best… everyone has a different situation and needs to educate themselves enough to figure out how to meet their needs now and in the future.

Flexo, overall it is a great post but you got the grade way wrong on “always save 10%”. This may work for the very few that start very young but for most the number is likely closer to 18%-20%. Here is why 10% won’t work for 98% of us: link

Follow the link to the video from PBS even the experts say 10% isn’t even close! It is a must watch!

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avatar mbhunter

Here’s a couple more:

“Your tax rate will be lower in retirement.”

“An engagement ring should cost two months’ salary.”

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avatar Eric J. Nisall

@mbhunter – I absolutely HATE that misconception about taxes in retirement. Personally, I think that it is a sign of a lack of ambition and poor planning. I never understood why people always plan on having less money in retirement. You would figure that the deductions would be less since (hopefully) there will be no mortgage, and there are significant savings (and earnings) on retirement accounts. Also, non-retirement investment accounts will probably begin to be liquidated, increasing the income to go along with the lower deduction amounts. Of course this is probably the case for very few people, but something I feel can be attained with proper discipline and planning.

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avatar Terry

Is saving 10 percent of income realistic for someone earning minimum wage?

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avatar Luke Landes ♦127,535 (Platinum)

Terry: I think so. But it’s a process. You do what you can, until you can do better. And minimum wage is an interesting issue… some people can move beyond minimum wage, and others who are stuck in that situation for external reasons, while rare, might not have as much flexibility.

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avatar Shogun @ Financial Samurai

Flexo – I’m pretty comfortable with the 4% withdrawal rule. Actually, I’m living it now and living off an income of about 4.5% (taxable) every year. One can find 3.75%-4% 5-yr CDs even now, when interest rates are at all time lows. It’s very doable.

Just be prepared for the inflation rocket ship!

Shogun

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avatar Jason @ Redeeming Riches

I guess I’m not as down on rules of thumb as some here.

A rule of thumb is not meant to be specific or applicable to every situation. They are what they are – a basic guideline to point folks in the right direction.

If somone is not saving at all, then saving 10% of your income (whether pre-tax or after) is a GREAT thing! Just so long as they are saving.

I agree that one should not stop at a rule of thumb and consider themselves to have a “financial plan” – but if it helps move from inaction to action, then the rule of thumb has worked.

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avatar Luke Landes ♦127,535 (Platinum)

Jason: that’s a perfect example of how rules of thumb, as substituted for knowledge and critical thinking, can be very dangerous. Implementing a rule of thumb, say saving 10% of your income, invites a feeling of completion. The biggest problem is that the person who has now achieved this rule of thumb is likely to stop thinking! They made their goal, and if the rule of thumb holds true, they are set for life. Rules of thumb invite inaction or insufficient action.

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avatar Jason @ Redeeming Riches

I totally understand the point you are making, however, someone can “stop thinking” even if they lay out a perfect financial plan.

I don’t think a rule of thumb leads to insufficient action no more than a quality, critically thought out goal leads to action.

Knowledge doesn’t equal action. Application of the knowledge leads to action.

I think you’re right though in that if we stop progressing and trying to find ways to save more & invest more wisely etc then the financial plan has failed.

My point is that rules of thumb provide starting points – not ending points.

For some who have a hard time getting things in order, a basic starting point is a good way for them to get going in the right direction.

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avatar Retirement Savior

Good article…I like it when one question’s long held assumptions. The 4% plus inflation increase is a quality idea. However, I worry though that some of the suggestions could be unrealistic. For instance, having an emergency fund based on the unemployment rate would be very tough, if you had to have a year’s worth of savings set aside. It would certainly be ideal, but tough to accomplish.

Also, with the volatility of stocks, I think that a 70-80% allocation could be dangerous for someone in or nearing retirement. They would need to prepare for 30-40% possible drawdowns over a period of years with that kind of portfolio.

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avatar Mike

Regarding the 4% withdrawal rate. You should read “Four Pillars of Investing” by William Bernstein for a great explanation of it.

I think that rule deserves a better grade – perhaps a “B”. It’s still not perfect since flexibility is important (which defeats the purpose of all rules of thumbs.

You’ve also mixed together asset allocation with the safe withdrawal rate. Beginning retirement with 100% stocks is just plain risky – which has nothing to do with the withdrawal rate.

As for the 80% of pre-retirement income I think this one is completely ridiculous and deserves an “F-”. You need money to cover your expenses in retirement – whatever those expenses might be. The relationship to your pre-retirement income is tenuous at best.

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