When I was a kid growing up on a farm, I learned that not every task requires great precision. Once, my dad asked me to stack hay 30 feet inside the barn door. I didn’t look for a tape measure. Instead — knowing my strides are about three feet long — I took 10 strides from the door and got to work. There are lots of financial “rules of thumb” designed for the same reason: to give you a rough idea of what to aim for, so you can get to the work of achieving your financial goal.
I find financial rules of thumb thought-provoking and sometimes action-provoking. But if you expect a financial rule of thumb to give you an accurate answer for your personal situation, you’re using it wrong. No rule of thumb is that reliable.
Sometimes “-ish” is okay
There are times when it’s okay to settle for information that is only directionally right. For example, if you’re 45, it’s reassuring if a rule of thumb suggests you’re on track to retire at your goal of 65-ish. I think it’s also okay to estimate whether the annual retirement income you can expect to start in 20 years would be $40,000-ish or $60,000-ish.
In contrast, if you’re thinking of retiring within the next five years, you need crisp, reliable answers that don’t end in “-ish.” Here’s my take on the reliability of various financial rules of thumb:
- Your retirement income needs to be 70% of your working income. Unreliable. It's a one-size-fits-none rule. Instead, identify which expenses will disappear when you retire (such as transportation to work or RRSP contributions). Also, will your retirement lifestyle be on the costly side (travelling around the world) or the frugal side (growing your own vegetables)? My wife and I highly recommend this three-step exercise. Consider: 1. the lifestyle you want and what it will cost; 2. how your expenses will change; and 3. what your income needs to be. This isn't a replacement for a financial plan, but it's a start.
- Keep an emergency fund equal to six months' income. Somewhat reliable. A six-month fund would be handy if you had a temporary job loss or your car needed a major repair. But having no credit card debt and having access to a line of credit would also help in a short-term emergency. Insurance is the best way to protect against catastrophes (such as death or critical illness) that six months' savings won't cover.
- Don't pay more than 3.5 times your gross annual income for your house. Fairly reliable. This should give you the financial latitude to tackle other goals, such as saving for your kids' education or your retirement. In expensive real estate markets, this is a tough rule to live by. In my working days, we compromised and chose to work and live largely outside of the expensive Greater Toronto Area.
- Don't invest more than 5% of your savings in any one stock or bond. 100% reliable. My cousin Johnny “bet the farm” on a particular tech stock when it was Canada's darling. (Actually, as a farmer, he bet everything but the farm.) When the stock crashed, so did a huge chunk of his net worth. I've also been burned when I've invested heavily in exciting investments that made headlines.
- Accumulate 20 times your gross annual income, then retire. Reliable but not realistic. I was able to save 10 times my annual income, but I wouldn't use that as a rule of thumb, either.
- Never touch your retirement savings, except for retirement. Perfect!
- In retirement, you can sustainably live off of 4% of your nest egg. This is controversial. With today's low interest rates and Canadians' greater longevity, some experts warn that with a 4% payout, you may still run out of money someday. As an early retiree, it's been especially vital for me to monitor my payout rate, because my nest egg will have to last longer. In my first three years in retirement, it was 2.95%, 3.32% and 2.97%. (Disclosure: On top of those payouts, I also earned some money from a bit of freelance work. I don't think most people could retire comfortably on 3% of their nest egg alone.) Another consideration is the potential for significant, unexpected health care costs. Really, you need a financial plan to guide you on sustainability.
- If your employer matches your contributions to a workplace savings plan, go for it. Absolutely! Sacrifice other things, but make this happen. It's like getting a guaranteed return and extra income.
- The percentage of your portfolio in bonds and fixed-income investments should be equal to your age. Hmm . . . that advice worked better when bond yields were higher. (As a reminder, this rule of thumb says that if you're 55, you should have 55% of your portfolio in relatively safe bonds/fixed investments/cash and the other 45% in equities.) I'm 58 and I wouldn't be getting enough income in today's environment if 58% of my investments were in bonds. The flip side is that being more heavily invested in equities is riskier.
- Total home ownership costs shouldn't exceed 30% of your gross income. Pretty reliable. This includes mortgage payments, home insurance, heat/hydro/water, property taxes and condo fees. If you limit your housing costs, you can consider other goals in life -- not just having a house.
- Your total debt servicing costs shouldn't exceed 40% of your income. I like this one, too. This includes everything in the 30% list just above, plus payments on car loans, credit cards and other debt. Following this rule made it possible for my wife and me to save for retirement and for our kids' education.
- Don't plan to retire with debt. I agree 100%.
- You need to have x times your annual income in life insurance. Never rely on a life insurance rule of thumb. Instead, talk to a financial advisor about what you need. When I was working, I was our family's sole income-earner. If I died, my wife and two kids would have had no income at all, so I saw buying life insurance as the most important financial decision we made.
- Save for your retirement before your kids' education. Probably reliable, but . . . only if you're truly in an either/or situation. Ideally, do both. Remember that your kids can borrow to pay for school costs, but you can't borrow to retire.
- If you carry a credit card balance, find the lowest-interest-rate card. If you don't carry a balance, find the lowest-cost or highest-reward card. Totally reliable.