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« Ten Things About Which I Am Certain | Main | File and Suspend? »
Monday
Oct152012

Financial Rules of Thumb

A recent article in The Wall Street Journal mentioned a new “rule of thumb” for retirement saving that I had not seen before.  This article brought to mind the many rules of thumb financial industry folks use to simplify otherwise complex issues.  Rules of thumb are poor substitutes for getting into the numbers and doing a proper analysis, but they do offer an easy way to approximate values and see if one is in the right neighborhood.

Here are ten well-known financial rules of thumb:

  1. Total monthly debt payments should be no more than 36% of gross monthly pay
  2. The percentage of your portfolio in bonds should equal your age
  3. Pay yourself first and save at least 10% of your salary
  4. Always save enough in your 401k to get your employer’s match
  5. No more than 10% of your total savings should be in your employer’s stock
  6. Your emergency fund should equal three to six months of household expenses
  7. The Rule of 72: to determine how long it will take for a sum to double, divide 72 by its return; an investment earning 8% will double in approximately 9 years
  8. A diversified stock portfolio will average returning 10% over time (this one may be suspect for the years immediately ahead of us)

10.  One should have about 5 times their annual salary in life insurance

 

 

Those are but a few of the numerous “rules of thumb” that have found their way into the financial lexicon, and they have proven useful to guide our initial thinking about a topic, but back to The Wall Street Journal article I recently read.  It caught my eye because it reported on a new rule of thumb related to saving for retirement, a topic much discussed.  It seems that Fidelity Investments, the nation’s largest provider of 401(k) plans, recently suggested that “eight” may be the “magic” number for the typical wage earner; i.e., the typical wage earner should aim to save at least eight times their final annual pay to insure that they will be able to afford basic living expenses in retirement.  Of course, they did not define a “typical wage earner” or “basic living expenses.”  With this approach, Fidelity did assume that one would need to replace about 85% of their final pay.  This is based on the fact that retirees have shed those work-related expenses, don’t face payroll taxes, and supposedly no longer have to save for retirement. 

Bert Whitehead, founder of the Alliance of Cambridge Advisors and author of the book, Why Smart People Do Stupid Things With Money, uses a different rule of thumb as he has suggested that one’s nest egg should be about 25 times a recent retiree’s planned annual spending. This is another way of citing the rule that suggests one can plan to withdraw about 4% per year from their retirement savings and expect that it will last for a thirty year retirement. 

Fidelity also offered benchmarks so folks can measure their progress.  They suggested that by the time one reaches the age of 35, they should have saved an amount equal to their annual salary; by 45, that amount should be about 3 times their salary; and by 55, five times their salary.   Vanguard Group, another industry giant, is more conservative and urges folks to simply save 12% to 15% of their salary each year to assure a secure retirement.

Rules of thumb are intriguing.  They often prod us to further inquiry and self- examination, but they cannot possibly apply in a great many situations simply because each family’s situation is different.  Finding the numbers that apply to our own unique situations will necessarily require much more than referring to various rules of thumb. For example, we really cannot know how much we need to save for retirement until we have a good idea of what kind of retirement we envision, and how much it may cost.  There are a number of online resources that can take you further than any particular rule of thumb, or you can always seek the help of a financial planner.

Remember, money is not the most important thing, but still, money matters.

15 October, 2012

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