It’s surprising to me how often financial pundits reference financial rules of thumb. Sometimes they may actually be in favor of what they’re espousing, but it often seems like a shortcut to doing research. I recently read an article where the writer referenced budgeting and included the maligned 50/30/20 budget. Don’t simply believe these rules because you see them referenced more than once. Here are some of the more common rules of thumb that shouldn’t simply be accepted as true:
You will need 80% at a minimum to have a comfortable retirement
Oh, there are so many things wrong with this statement. First, it can make your retirement goal seemingly impossible. I mean, if you are making $120,000 per year and you need 80% of that goal, you would need $2.4M (if you use the also over-referenced rule of thumb that you will withdraw 4% yearly – more on this one in a minute). Over two million dollars…
Second, this rule is focused on the wrong input. Instead of looking at what you’re making, you should instead look at what you’re spending. Our family spends 35% – 40% of our net income every year on bills, miscellaneous expenses, and house/car maintenance. If you’re planning for retirement, wouldn’t you start with your actual spending and work from there? We might need 80% if we decide to travel extensively or buy a vacation home. But we may need only 30% if we’re the kind of people who are happy gardening or having only one big trip per year.
All debt is bad debt
There are several financial writers who constantly scream reduce debt, debt is bad. They suggest you never go into debt for a car loan and pay off your house as quickly as possible. I’m not here to tell you to run up credit card debt. But well-managed debt is a tool that many people can use responsibly. These writers don’t believe it, but there can be good debt along with bad debt. And sometimes it makes more sense to go into debt while investing the saved money you would have spent. For example, we just paid off our car. We purchased it with a significant down payment and were paying just under $400 per month (at 1.98% interest). During the majority of the time we had this loan, we were able to invest in our retirement accounts and also a taxable account when the markets were returning more than 10% per year. If you can manage debt, I see no reason to potentially have cash liquidity issues just to pay off a car in one fell swoop.
Save x% of your income
Many people say that if you save a certain percentage of your income, you will be fine for retirement and will have no money issues. Maybe it’s 10%, maybe it’s 20%, but whatever their golden rule is will bring you stress-free happiness. What happens in real life is often quite different. Young people may have a difficult time saving at all. This is when saving just enough to receive the free-money match from their 401(k) may be enough. Kids come along and you’re trying to split retirement saving with funding a 529 plan. College costs roll in perhaps at the same time you’re taking care of your parents. Saving 10% per year often just doesn’t fit into your life.
Instead of subscribing to a set percentage, consider this approach: invest until it hurts. Start when you’re young with the full percentage to earn the company match. Then – either automatically or by contacting HR – raise the percentage one or two percent per year. Keep doing this until you start to feel it or maybe things get a little tight. Reevaluate your spending and try to keep saving more to reach your goal.
The best option is to determine what you think you will need at retirement, and work your way back to see how much you need to save every year. If you know you are purchasing a house in two years, maybe you lower the contributions to your retirement plan for a year before and after the purchase, then dive back in once you’ve settled in.
Before you can invest you must be a financial wizard
I can’t believe I’m writing this, since I would love for people to feel they need to keep reading my blog. However, today’s world is different than when I was 20. My first job had no retirement plan. To learn about investing, I was at the library reading Value Line Investment Survey on Saturdays. I chose my appropriate asset allocation without the benefit of a robo-advisor. And like most people, I invested in actively managed funds.
My kids are going to have it much easier. My advice to them will be to determine what percentage to save and invest it in a free or low-cost stock index fund. If they want to play around with some of their portfolio, consider taking 5% and either investing in individual stocks or sector funds. And if they don’t like Dad’s advice, use a robo-advisor.
I’m not saying they don’t need to understand what a stock is. And learning about the inner workings of a credit card is mandatory reading in my opinion. My suggestion would be to learn what they need when they need it. If they are buying a house, learn about how to compare mortgages. If they are investing in a stock fund, learn about how to compare stock funds. Learn over time. But don’t be paralyzed by not immediately knowing everything about the difference between municipal bonds versus junk bonds versus I series bonds if you aren’t even investing in bonds.
Invest your age in bonds
I thought this had died out years ago. The idea is you invest your age in bonds, then 100 minus your age in stocks. Pure insanity. There are people who are 25 (by this rule they would invest 75% in stocks and 25% in bonds) who should invest less in stocks, but that’s because they are risk-averse. Many people in their 40s and older still invest 90% or more in stocks. You should invest based on your goals, time horizon, and risk tolerance.
Unfortunately risk tolerance is a hard nut to crack. I’ve been through several market corrections, including when markets tanked after Covid and more recently with inflation. Each time I’ve felt it like a punch to the gut. But I believe in the US economy and trust that it will come back. I’m willing to invest more in stocks because I don’t sell when my portfolio is languishing. If you are tempted to sell when your investments drop or if you can’t sleep at night, consider reevaluating your asset allocation to provide a less-risky portfolio.
Your money will last through retirement if you withdraw 4%
Even though I don’t subscribe to this rule, I referenced it earlier. This all arises from a well-known study showing that people who withdraw 4% per year (indexed to inflation after year one) would likely have sufficient money if it was invested in a 60% stock/40% bond portfolio. The advice was based on 30-year rolling periods starting in different years to see how long a portfolio would have lasted.
I see 4% more as a goal for retirement spending than a rule. Here’s why: much of your retirement success will be due to the first few years you are retired. If markets are good when you first retire, you may be able to withdraw 5-6%. If markets are bad, you may be going back to work.
The main problem I have with this though is people aren’t robots. Throughout our lives, most people naturally react to a shortage of money (or the recent increase in inflation) by spending less. Why won’t we do the same in retirement? Similarly, if we have a little extra money, maybe we take an unplanned trip. Instead of a set 4%, find a percentage to begin with and make tweaks based on your needs and your portfolio’s returns.
Your success in investing is up to you. That means how you save and how you spend should reflect what’s important to you and what matches your goals and values. These rules of thumb are a great way to learn more about finance. But they can be dangerous too, especially if you think you have to amass this huge quantity of cash to retire. It may seem easier to just throw up your hands and say I’ll never save enough. Before you do, look at your particular situation. There’s usually a path that will take you where you want to go.