Financial advisers and, yes, journalists love to offer “rules of thumb” for managing your money.
- The percentage of your 401(k) that should go into bonds should equal your age.
- Don’t pay more than 2.5 times your salary for a home.
- College students shouldn’t borrow more than what they expect their starting salary will be after graduation.
- You should have five to seven times your annual salary in life insurance.
- And here’s a new one from Fidelity, the mutual fund behemoth: You need to save eight times your pre-retirement salary to meet your basic needs in retirement.
I could go on, but you get the point (and my editors would rebel).
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The 'Rodney Dangerfields' of Money Management
Rules of thumb are easy to dismiss. They’re the Rodney Dangerfields of money management: They get no respect. They’re gross simplifications that don’t deal with the complexity of individual and family circumstances. Some caustic financial planners call them “rules of dumb.”
Problem is, money rules of thumb exist for good reasons.
For one thing, think about the world you live in. It’s a complicated, uncertain, risky place swirling with information, misinformation, knowledge, gossip, rumor, numbers, data, falsehoods and so on. Because we live in a complex environment, we need simple rules of thumb, what Nobel laureate Herbert Simon called heuristics.
For another, unless you’re in the finance business, you have only so much time to deal with money issues after doing your job, raising kids, nurturing relationships, volunteering and, perhaps, having some fun.
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Mental shortcuts – rules of thumb – can be invaluable for making sensible decisions. “In complex environments, decision rules based on one, or a few, good reasons can trump sophisticated alternatives,” write British regulator Andrew Haldine and economist Vasileious Madouros in their paper, The Dog and the Frisbee. “Less may be more.”
Good and Bad Money Rules
The big question is how to distinguish good rules of thumb from bad.
It’s an issue that Michael Mauboussin has thought a lot about as chief investment strategist at Legg Mason Capital Management, adjunct professor of finance at Columbia Business School and author of The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing.
Mauboussin believes rules of thumb are usually a safe starting point for the kind of money questions through which you can derive reasonable answers by plugging data into a calculator or computer. But rules of thumb become dangerously misleading the more uncertain and unstable your information is. “It’s a continuum,” he says.
At the safe end of the continuum lies the rule of thumb: “Pay yourself first and save at least 10 percent of your income.” With this one, you can run the numbers on your computer and see where you’ll be in a few years.
Yes, to figure out exactly how much you should save for your goals, you should ideally gather as much information as possible, consider your savings options, weigh the probabilities and tailor your personal savings rate to your household circumstances. But if you don’t have the time to do all that, you’d be fine sticking with the savings rule of thumb for a few years before getting around to a more rigorous analysis.
The Worst Money Rule of Thumb
At the other end of the continuum is what I consider the worst financial rule of thumb: In retirement, you should withdraw an amount equal to 4 percent of your retirement savings plus the inflation rate each year. (The rule assumes that when you retire, 60 percent of your portfolio will be in stocks and 40 percent in bonds.) “A rule of thumb like this can leave you high and dry,” Mauboussin says.
First, should you really have 60 percent of your portfolio in stocks at retirement?
Second, the rule is based on historic market data, but what if investment returns in the future don’t mirror those of the past? If returns are lower, you may run out of money withdrawing 4 percent of your savings each year.
Wade Pfau, associate professor at Japan's National Graduate Institute for Policy Studies, has studied this very question and his results are sobering for aging boomers: Instead of 4 percent, you may want to think about an annual withdrawal rate of 2 percent or less.
Simply put, there is way too much uncertainty to rely on a simple rule of thumb for making your retirement money last.
Another rule of thumb I find worrisome is the one that says you should have enough savings to live on 70 to 85 percent of your pre-retirement income during retirement.
Yes, I know you have to start from some kind of baseline, but this is a classic case where averages are highly misleading.
The percentage of pre-retirement income that could work for me might be very different for you. I don’t think you can avoid digging in the weeds of your finances, values and goals to come up with a realistic benchmark for retirement living expenses.
Fidelity's Retirement Savings Rule
I think the new Fidelity rule to save eight times your pre-retirement salary is slightly better along the rule-of-thumb continuum, maybe nearing neutral ground.
The Fidelity rule is actually a little more nuanced. The financial services firm says the typical worker should have saved about three years worth of salary at age 45, five times at age 55 and eight times by retirement at age 67.
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It’s similar to a rule devised by Brett Hammond, formerly chief investment strategist at TIAA-CREF. He figures that if you’re 45 and plan to retire at 65, you’ll need 3.6 times your salary to be on track. At 55, the multiple rises to 5.4 times. By the time you retire at age 65, you'll want it to be 7.7 times. Both of these gauges rest on a number of assumptions, like an expectation that you’ll want to replace 85 percent of your pre-retirement income (Fidelity) or 70 percent (Hammond).
The way I look at the Fidelity and Hammond retirement savings rules is that they provide a ballpark guesstimate. So take them with a huge grain of salt (OK, maybe a salt block).
Still, I’ve occasionally run these types of “how am I doing” numbers on my computer screen and they’ve served as a wake-up call to take a deeper look into my retirement savings. (Next Avenue has some good retirement calculators, including a Retirement Planning Estimator.)
All in all, I believe that money rules of thumb should get more respect or, at least, closer scrutiny. They can help simplify financial decisions, especially when so many people suffer from money paralysis and are overwhelmed.
Sometimes, less is more.