12 common financial rules of thumb and slogans (and whether they’re true)
There are many of financial planning-related rules thumb and guidelines often spoken and written about. But, how accurate are they?
Here are my thoughts on 12 common rules of thumb, principles or slogans you’ve probably heard before:
1) You should always contribute at least enough to your employer plan (like a 401(k)) to get the full employer match
GENERALLY TRUE
If you work for an employer that has a retirement plan that offers a match on the money you contribute into the plan, you can kind of think about that match as a 100% return on your money.
For example, assume your employer matches your contributions, up to a total match of 4% of your wages. And assume you make $100,000 of wages. If you contribute $4,000 (4% of your wages) to your 401(k), your employer will put in another $4,000 on your behalf. Just like that, you turned your $4,000 into $8,000, hence it’s more or less a 100% return.
However, many employer plans have some sort of vesting schedule, where you don’t fully own the money the employer puts in until a certain amount of years have passed. And if you leave before the amount of vesting time has passed, you don’t actually get to keep the money they put in; or at least not all of it. As such, it’s not entirely accurate to say the match is a guaranteed 100% return on your contribution, as there could be some strings attached.
Nonetheless, especially if you plan on staying at your employer long enough to get the match fully vested, contributing at least enough to get the full match is generally a good idea.
There aren’t many cases I can think of where it wouldn’t make sense to take full advantage of the match. But one possible scenario is if your day-to-day cash flow is very tight and you need every dollar of income you make to cover your living expenses. In that case, contributing money to your employer retirement plan could mean you don’t have enough money to pay your bills for the month.
While I firmly believe people should start prioritizing retirement planning and saving for retirement as soon as they become adults and/or join the workforce, I realize present-day needs sometimes take priority over future needs. Just be sure to try to not sacrifice future needs too much or for too long!
2) You shouldn't help your kids pay for college if it means shorting your own financial security in retirement
GENERALLY TRUE
I definitely agree with the reasoning behind this.
“Human capital” - the ability to use one’s mind and/or body to earn income through work - is generally the most powerful tool we have in generating income and accumulating wealth.
Many people in retirement no longer have the human capital lever to pull. Or, if they do, it may only be for limited wages or income. On the other hand, people in their 20s, 30s or 40s still have a lot of potential human capital and ability to earn income.
While I completely understand wanting to pay for some or all of your kid’s college expenses, I feel it shouldn’t be done if it means you’re putting yourself at risk of not having enough financial resources to provide throughout your retirement. Your kids have a lot of time to eventually earn enough to pay off their student loans. If/when you run out of money in retirement, you likely won’t be in a position to be able to go back to work to try to get more income.
However, I realize that some people place the highest of priorities on paying for some or all of their kid’s higher education. For whatever their reasons or values are, ensuring their kids go to college with no, or minimal, student loans is the utmost priority for them, even if it means sacrificing their own financial comfort in retirement. Personal finance is often more personal than it is finance. Which means values and beliefs will drive a lot of the decision making as it relates to finances. So long as you’re fully aware of the pros and cons of each financial decision you make, make the decision you feel is best for you.
3) You need at least $X million (where $X can be whatever amount someone wants to say) of savings to retire
FALSE
There is no magic number of savings that universally applies to everyone. Everyone’s personal circumstances will be different and will dictate how much money they need saved to comfortably retire.
For example, at one extreme, some people have sizable pensions and Social Security income that will more than cover all of their expenses in retirement. Granted, there may be larger or one-off expenses that those sources of income won’t cover. But, for all routine daily expenses, sources of guaranteed income like pensions and Social Security could be more than sufficient for some people.
As an example, assume a couple has $70,000 of Social Security between them, and one spouse has a pension of $40,000 per year. That’s $110,000 of guaranteed income per year, for life. And Social Security will increase each year with inflation (we’ll assume the pension won’t increase with inflation).
Let’s also assume this couple only has $90,000 of total expenses, including income taxes, per year. In this case, the people already have more income than they need each year. As such, they could potentially not have any savings and still be able to retire rather comfortably. In this case, they’ll actually be saving roughly $20,000 per year in retirement.
On the other hand, assume another person wants or needs the same $90,000 of total expenses per year, but only has Social Security of $40,000 per year and no other sources of guaranteed income. There will be another $50,000 per year of income that will need to come from somewhere. This person definitely needs a sizable amount of savings to retire, which is a very different scenario than the previous couple.
In this example, how much does the person actually need to retire and generate $50,000 of income per year for of typical expected retirement length of roughly 30 years??? That’s the million dollar question. While there is no exact answer to this as there are a lot of unknown future variables that will impact how much is ultimately needed, a historically conservative back of the envelope figure is to take the annual income needed and multiply it by 25.
In this example, if someone needs $50,000 a year out of their portfolio for 30 years, they should typically target to have $50,000 * 25 = $1,250,000 of portfolio assets when starting retirement.
Where did the multiplier of 25 come from??? See the next couple of rules of thumb down about the 4% rule. The 25 multiplier is just using the 4% rule in reverse…
4) In retirement, expect to need 80% of whatever your pre-retirement income was each year
COULD BE TRUE OR FALSE
This is another one of those things where it’s impossible to say if it’s accurate or not without knowing the person’s full financial picture, both present and future (technically, assumptions about the future, as we obviously can’t actually know the future with certainty).
I like that this rule of thumb at least tries to give people a more personalized starting point than the previous rule that says everyone needs $X million to retire.
Someone who spends $500k per year is obviously going to need much more money and/or income in retirement than someone who only spends $50k per year. With that said, trying to ballpark someone’s necessary retirement income, as opposed to assets, is a more logical starting point. However, this rule of thumb is still way too generic to be universally valuable.
As an example, if you make $100k per year in wages before retirement, this rule of thumb says you’ll need $80k per year in gross income in retirement. Is that accurate??? Maybe, maybe not.
There is at least one aspect of this logic that should hold true for basically everyone; all else equal, the amount of your gross income that’s shaved off for taxes will go down at least somewhat when you retire.
Specifically, I’m referring to the “payroll” tax or “FICA” tax portion of your earned income. Whether you work for someone else or are self-employed, chances are some of your income has a mandatory payroll tax to pay into the Social Security System (where the exception would be if you work for certain public employers whose employees are not required to pay into Social Security). And all of your earnings has a mandatory payroll tax to pay into the Medicare system.
When you stop working and no longer have earned income, you no longer have to pay the Social Security and/or Medicare payroll taxes on your income. As such, pound for pound, your net-of-tax income in retirement will be a bit lower than your net-of-tax income when you were working. But, it’s not going to be 20% lower. Which means in order for this rule of thumb to hold true, you’re going to have find other cuts in expenses between your working and retirement years for the rule to attempt to hold true. Some people will be able to trim their expenses more than others. Hence, this rule is too broad to be accurate for everyone.
5) The 4% "rule" is a good tool for determining how much of a portfolio someone can distribute each year in retirement
KIND OF TRUE, BUT WITH LOTS OF CAVEATS AND RESTRICTIONS AROUND HOW YOU APPLY IT
I’ve talked about the 4% rule at length before. Here’s a detailed podcast episode on the topic. If you’re not already familiar with the 4% rule, I highly recommend checking out the episode!
Anyway, as you’ll hear in the podcast, the 4% “rule” isn’t actually a rule. Instead, it was simply an academic exercise to see what the highest rate of starting portfolio withdrawals in retirement could have been over the last century without having run out of money in any 30-year period since then.
The research was originally conducted in the early 1990’s and used stock market, bond market and inflation data starting in the 1920’s.
It then looked at every rolling 30-year period from the mid-1920’s through when the research was done in the 1990’s. And it assumed someone starts retirement with an investment portfolio that’s 50% invested in large U.S. stocks, as represented by the S&P 500 index, and 50% invested in intermediate term U.S. Treasury Bonds.
It also assumed the portfolio was rebalanced every year to bring it back to a 50/50 stock-to-bond allocation.
It assumed the person would withdraw X% of their portfolio at the start of retirement, and then increase (or decrease) the dollar amount of distribution every year by the amount of inflation (or deflation) for the year.
For example, if someone started retirement with $1,000,000 of investment portfolio, the research started by making an assumption the person withdrew 6%, or $60,000, from their portfolio in the first year of retirement. And then it assumed that amount was increased (or decreased) every year for 30 years based on inflation (or deflation).
The research looked at what would have happened to that portfolio if the withdrawals started in the mid-1920’s and went for 30 years. And then it bumped forward the starting year by one year and looked at what happened to the portfolio 30 years from then. Etc.
At a 6% starting withdrawal rate, there were some periods since the 1920’s where the portfolio would have depleted faster than 30 years. And there were less, but still some, 30-year periods where the portfolio would have depleted at a 5% starting withdrawal rate. But there were no historical 30-year periods where the portfolio would have depleted if the starting withdrawal rate was 4%.
For better or worse, those findings have since been labeled by the industry as the 4% “rule.” In reality, it’s not a practical rule and can’t really be used precisely as laid out in the research. No one spends and/or distributes from their portfolio in rigid annual amounts like the research assumed. Or at least they don’t for entirety of 30 years. People’s needed portfolio withdrawals will fluctuate throughout retirement as their other sources of income change, as their life circumstances change their living expenses, as markets change and people feel more or less comfortable spending, etc.
As such, I would never recommend someone try to actually implement the 4% rule as it was detailed in its original research.
However, I still feel there is a lot of value in using the 4% rule as a data point in a person’s broader holistic retirement plan.
Specifically, I think the 4% rule is a good back of the envelope quick and dirty sanity check. For example, if someone has $1,000,000 of investable assets at the start of retirement, the 4% rule would say a $40,000 starting annual withdrawal, with inflation increases each year throughout retirement, is a historically conservative withdrawal amount to assume.
I say “conservative” because that is the highest starting withdrawal amount that wouldn’t have depleted a 50/50 stock-to-bond portfolio in any 30-year historical period, including during the Great Depression. In fact, there were some 30-year periods where the person would have ended retirement with more assets than they started if they followed the 4% rule.
Anyway, I think the 4% rule is a good litmus test for reasonability. If a person starts retirement with $1,000,000 and expects to take out $80,000 per year, (i.e. an 8% starting withdrawal rate), plus inflation, for all of retirement, I’d advise against it as the 4% rule research shows there would be a very high chance the person’s portfolio wouldn’t last all of retirement. But if that same person instead plans on only taking out $50,000 per year, plus inflation, I’d say that’s doable, historically speaking. However, we’d need to pay attention along the way and be willing to cut back if/when there is a serious and/or prolonged pullback in the markets during retirement.
As mentioned before, the concept of needing an amount of assets that 25x your desired annual spending is simply the 4% rule in reverse. 4% is a 25th of 100%. Whereas the 4% rule says a portfolio of $X can support annual withdrawals of $Y, the 25x thing looks at it in reverse and says if you want to withdraw $Y per year throughout retirement, you should target to start retirement with $X of assets.
6) Your target stock allocation percentage should be 100 minus your age
FALSE
This is another one that’s too generic to be right. Not to say it will never be right but, if it is, it’s likely just a coincidence.
The gist behind this is the notion that as a person ages and nears or enters retirement, they have less capacity to take on financial risk with their investments.
On the surface, that logic sounds right. However, like most things in personal finance, everyone’s circumstances can be different.
Recall the earlier example of a couple who have really large sources of guaranteed income from pensions and Social Security such that those things cover all of their anticipated income needs. In this case, the couple could be really aggressive with their investments, if they want. Because even if their portfolio drops precipitously, they’ll still be fine, financially (but emotionally might be a different story).
However, this rule would say all 70 year-olds should only have 30% of their portfolios in stock, as 100 minus their age of 70 equals 30.
Having only 30% stock allocation is potentially WAY too light for the hypothetical person with really large pension and Social Security. And it’s even likely too light for most folks who do need to rely on their portfolio for at least some of their future income needs.
On the flipside, a 20 year old who’s decades away from needing to touch their retirement savings should almost certainly have more than 80% (i.e. 100 minus 20) of their portfolio in stocks. They have plenty of time on their side to ride out rough spells in the market and benefit from the likely favorable long-term portfolio appreciation of a higher than 80% stock allocation.
7) You should pay off your mortgage before retiring
COULD BE TRUE OR FALSE
Here is a prime example of the idea that personal finance is more personal than it is finance:
From a pure dollars and cents perspective, it could make sense to not pay off your mortgage early. A good example would be if you have a mortgage with an annual interest rate of only 3%.
Assume you have $100,000 of balance left on your mortgage. And further assume you have $100,000 of cash that you could use to pay off the loan at any time. Also assume you currently have all of that cash sitting in a high yield savings account or invested in Treasury Bills earning more than 4% interest.
Objectively speaking, you’re better of not paying off your mortgage because you’re earning over 4% interest on your cash and only paying 3% on your mortgage. On net, you’re making 1% interest by not paying off your mortgage.
If, on the other hand, you took the $100,000 of cash and paid off the mortgage, you’d save yourself the 3% interest expense but would lose the 4% interest you’re getting on that cash. In other words, you’d lose the net 1% interest you were getting.
However, even if the math says you’d be better off keeping your mortgage, you may have very important reasons for wanting the loan paid off. In which case, that could be right answer for you, and the emotional or subjective benefits of not having the mortgage could more than outweigh the net 1% interest you were getting by keeping the loan outstanding in this case.
As an example, for whatever your reasons are, maybe it’s always been a major goal of yours to have a fully paid off house before stopping work. In that case, don’t let someone tell you that you shouldn’t pay off your mortgage, especially if you have to funds to do it!
8) The rule of 72 is a good tool to tell how long it will take to double your money in an investment
TRUE
This is a cool one, and it’s simply math.
If you want to know how long it will take to double your money in a given investment, divide 72 by the rate of annualized compound interest you expect to earn and the result will be the number of years it will take to double.
For example, assume you have an investment where you can reasonably expect to get 6% annualized returns over the long term. Dividing 72 by 6 equal 12. That means at 6% annualized compound interest, you’ll double your money in 12 years.
The math isn’t exact. In this case, you’d actually slightly more than double your money in 12 years (your money would be 2.01x larger if getting 6% returns each year). But it works well enough for most realistic and reasonable assumed rates of interest. It doesn’t hold up at the extremes though.
As an example, assume you could somehow earn 72% interest per year. If you divided 72 by 72, you get 1. Which would mean this rule would say you’d double your money in 1 year if getting 72% interest. You can tell without using a calculator that this one doesn’t hold up. In one year, you’d only have 72% more than your started with…definitely not doubling your money.
And at 20% interest, this rule would say you’d double your money in 3.6 years. But, in reality, you’d only have 93% more than you started with in 3.6 years.
But for rates of interest less than 12% per year, this rule holds up well enough for me to call it true.
9) You should have an emergency fund of cash equal to three to six months of expenses
COULD BE TRUE OR FALSE
There is definitely merit behind the idea of having an emergency fund of cash to cover any big and unexpected expenses that might arise. But what’s the right amount of cash to have??? That’s hard to answer and will depend on each person’s circumstances.
If someone is in the thick of their working years, especially if they’re the sole bread winner for their family, having a sizable emergency fund is exceptionally important. For example, if that person loses their job, what’s to say it won’t take them the better part of a year, or maybe more, to find new work? In that case, only having enough cash to cover three to six months of expenses won’t be enough.
On the other hand, for people in retirement who aren’t dependent on wages to pay for day-to-day expenses, having an emergency fund, in the normal sense of the word, arguably isn’t as necessary. Because they don’t have wages that are at risk of stopping.
However, that’s not to say there can’t still be large and unexpected expenses that may pop up. Like needing a new car all of sudden. Or having a major out of pocket medical expense. Or needing a new HVAC system out of the blue.
More broadly though, I think it’s good practice for retirees to have a cash cushion more so for helping manage sequence of return risk and not necessarily as an emergency fund, per se.
Sequence of return risk essentially means having to take money out of your investable portfolio when your investments are down in value. Such as during a stock market pull back. Specifically, having bad returns at the beginning of retirement (and good returns at the end) is more detrimental to your portfolio than having good returns at the beginning (and bad returns at the end). That would be a bad “sequence” of returns. And minimizing how much of your investments you have to sell off in those early bad market years is the goal in trying to soften sequence of return risk.
In a perfect world, to help manage and mitigate sequence of return risk, you’d have a pot of cash or other very safe and stable source of income if/when needed to pull from when all of your investable assets are down in value. Such as the case of 2022, where both the stock and bond markets were down materially. By pulling from a cash cushion instead of selling off investments, you would have helped avoid selling investments when they were down. By not selling them, you could have given them time to hopefully rebound in the future.
But the big question is how much cash cushion is enough to account for potential bad sequence of returns??? There isn’t a universally right answer to that. I think anywhere from one to three years of cash needs is a good target to shoot for. And it’s just cash needs above and beyond whatever your other sources of guaranteed income provide. For example, if you need $100k per year of income but are already getting $60k from pension and Social Security, then it’s just $40k per year that I’d consider the amount of one-year cash buffer to shoot for.
10) Permanent life insurance should be avoided; only use term life insurance
FALSE
I’m not saying everyone needs permanent life insurance. But I am saying it’s bad advice to make a sweeping dogmatic comment like permanent insurance should be avoided. For some people, that comment is true. But not for everyone.
Furthermore, I definitely feel (to the point I’m confident in saying I know) that forms of permanent insurance like whole life insurance and indexed universal life insurance are often oversold and often sold inappropriately. But that doesn’t mean everyone should avoid them.
There are definitely some scenarios where a form of permanent life insurance is the right and best solution. In those cases, it would be poor advice to tell someone to not consider it.
Some common examples where permanent life insurance is a great solution (and better than term life insurance) are as follows:
When wanting to ensure a certain amount of legacy is left to heirs, regardless what happens during your retirement. Let’s say you want to make sure you leave at least $500,000 to your heirs. You could buy a permanent life insurance policy with a $500,000 death benefit and fully pay the premiums during your life. That way, you know there will be at least that amount of money going to your heirs when you pass.
When needing to ensure there will be liquidity to administer your estate. Some people have very large estates, but lack liquidity. For example, assume a single person owns $20,000,000 worth of land but not much else. They will owe estate taxes on the value of that land when they die. Specifically, as of 2024, they’d owe about $2.6 million of federal estate taxes (plus state estate taxes, if applicable). Without having to sell off some or all of the land, the estate won’t have money to pay the taxes owed. Having a permanent life insurance policy large enough to cover anticipated estate taxes (and other estate expenses) could be a great solution that would prevent having to fire sale the land after the person’s passing.
Funding a buy/sell agreement between business partners. If someone owns a business with a partner, and the plan is the partner will buy the person out after the person dies, a permanent life insurance policy on the life of the person could ensure the partner will have enough cash to buy out the deceased person’s interest in the business after passing.
There are a few other examples where permanent life insurance can make sense, in my opinion. It’s definitely not something that everyone needs or should be sold. But it also shouldn’t be blindly disregarded, either.
11) The owner of a large investment advisory firm says, "I hate annuities and you should too"
FALSE
This is categorically terrible advice. And I frankly don’t know how regulators let this person get away with saying this.
There are no doubt people who sell annuities who are extremely biased and try to sell annuities as the cure to all financial needs. But, on the other extreme, there are folks like the person who says “I hate annuities and you should too” who are equally as biased and wrong for taking the stance they do.
Annuities are a tool. They are neither good nor bad on their own. There will be circumstances where they’re the best solution, and there will be circumstances where they should be avoided.
There are various different types of annuities that do different things. It’s unfair and a disservice to paint them all with the same brush and say they’re all bad.
For a primer on annuities, check out my firm's February 2023 edition of its newsletter. If you approach annuities with an open mind and remain agnostic to learning how they work and when they can make sense, you’ll realize nobody should say they universally hate annuities. They are simply tools that do certain things. Maybe someone could benefit from an annuity, or maybe they couldn’t. But everyone’s circumstances and needs will be different.
For what it’s worth, the person who says “I hate annuities and you should too” owns one of the country’s largest investment advisory firms. And his firm gets paid only on the size of the investable assets they manage for their clients. Furthermore, the firm doesn’t have any insurance licenses and therefore can’t sell annuities. With that said, if/when one of their clients were to take money out of their investable accounts to buy an annuity, the firm’s revenue would directly decrease as a result. See the glaring bias and conflict of interest in the owner of that firm saying everyone should hate annuities???
12) That same person also says of his firm, "we do better when you do better"
PARTIALLY TRUE BUT MOSTLY FALSE
This statement is from someone whose investment advisory firm’s fee is a percentage of client’s account sizes under his firm’s management. All else equal, the larger a client’s account size, the more the firm gets paid, and vice versa.
That’s the notion behind saying “we do better when you do better.” The person says it inherently only in reference to performance of the investments in the client’s account; if they go up in value, the client does better. And because the firm’s fee is directly keyed off account size, the firm also does better. Sounds good so far.
BUT, what’s to say the client’s investments wouldn’t have increased more at some other firm, or if they were self-managed by the client? In that case, even though the accounts are indeed going up in value at the advisor’s firm, the client could actually be worse off with that advisor than if they had their accounts elsewhere. So, is the client really doing better at that firm??? The honest answer is we’ll never know, because we can only hypothesize about what the client would have invested in if they weren’t with that firm.
Also, account sizes increase for more reasons that just investments going up in value. Account sizes also increase when clients deposit more money into the accounts at the firm.
With that said, if the firm convinces the client to roll money out of their 401(k) and put it into an account at the firm, the firm definitely does better because they will be paid more. But is that rollover better for the client??? Maybe, maybe not. There are definitely times when it’s better for people to leave money in their employer retirement plans instead of rolling them out to other accounts. Check out our August 2024 blog article for a full summary of all of the pros and cons of employer plan rollovers.
When advisory firm’s fees are based purely on client account sizes, such is the case with the typical percent of AUM (or Assets Under Management) fee structure, the firm no doubt does better when clients put more money into their accounts. But that doesn’t necessarily mean the client is actually doing better.
Conversely, the percent of AUM fee structure means the advisory firm does worse when the client takes money out of their accounts, as the firm’s revenue directly goes down as a result. But, maybe the client is better off taking the money out to do something else with that money. Such as paying down their mortgage, helping a financially strapped family member, buying an annuity, etc. In these cases, the client would be doing better by taking money out of the firm’s accounts. But the firm would be doing worse because their revenue would decrease. Which means that’s a very obvious inherent bias and conflict of interest for the firm.
As such, the “we do better when you do better” slogan is far from always accurate. It would be more accurate and honest if they reworded it to say, “we do better when you put - and keep - more of your money with us.” But I suppose that doesn’t sound as nice…
That’s it. I hope you found this helpful!