Thomas Edison reportedly once noted that rules stand in the way of accomplishment.
That may mean that a lot of people are falling short of their financial goals because they’re following what they believe are “the rules” of personal finance.
The good news is that people are thinking about these guidelines – because most of these financial maxims allow people to make decisions without thinking about them – but the bad news is that when it comes to one-size-fits-all advice, there’s a significant difference between covering the situation and looking good as you go through it.
Here are some rules that readers asked about, with a breakdown on how they, well, break down:
1. Set aside 10 percent of gross income for savings.
Experts say this is less of a rule than a starting point, although many people make it a target. It’s hard to peg “the right percentage to save” because it ignores several factors, like the return that the money can earn, the time available to build a nest egg and the lifestyle of the saver. This rule gets people to save — even if they can’t afford to get all the way to 10 percent of income – so it’s better than nothing, but if you follow this maxim expecting it to deliver a secure retirement, you may be sorely disappointed.
2. Keep three to six months of salary in an emergency fund.
It could take years for you to save up six months of salary, and keeping that money liquid for emergencies sacrifices its earnings potential That’s why most financial advisers now think that the disaster-preparedness savings should focus on living expenses, rather than gross income. Focusing on expenses ensures that the emergency fund covers its intended purpose, which is paying the bills, not replacing lost paychecks.
The need for emergency savings varies by circumstances.
The average consumer will never face an emergency that requires them to come up with six months of salary within 24 hours; as a result, some advisers suggest keeping the emergency fund to a minimum except when you feel threatened, and to allow for conservative, liquid bond investments for the money that you would tap into in the event a catastrophe overwhelms your disaster cash.
3. Life insurance benefits should equal five times current income.
Depending on who you talk to, this is either a longstanding insurance industry marketing ploy or an honest benchmark Either way, it’s focused on the wrong thing by, again, being based on income rather than expenses.
Experts say the five-times-income rule applies to the sole breadwinner in a family with two kids. That makes it inadequate for larger families, or a waste for people yet to start a family.
Like most financial rules of thumb, suitability here is a function of your personal situation. The real rule with insurance should be “Insure what you can’t afford to pay for without coverage.” For most people, that means insurance needs to be sufficient to cover their mortgage balance, the kids’ college education, funeral costs, and several years of expenses to allow loved ones to get back on their feet emotionally.
4. One-third, one-third, one-third: Set aside roughly one third of your total earnings to cover taxes, another third for living expenses and the rest for savings.
This rule can work, provided your total earnings are neither very high – when you would be spending excessively — nor very low (when you might struggle to get by on the small expense budget). There’s also the problem of how difficult it is for most people to actually set aside more than 30 percent of income into savings, making the input on this rule more unreliable than the outcome. As guidelines go, this is catchy. In real-life application, it’s sloppy and its success is more likely dumb luck than sound thinking.
5. If you can live on less than 5 percent of the savings you amass by the time you hit retirement age, you will not outlive your money.
The merit to this rule is that it forces you to think about what you could live on, and then to save enough to generate that income. Thus, if you believe you can live on $50,000 per year to live comfortably in retirement, you would need to amass $1 million in savings. With conservative returns and reasonable market conditions, you’d have a good shot at living off the interest and not eating into the principal too much, even though most financial advisers live by the 4 percent withdrawal rule (which was discussed here last week). Of course, if you want $100,000 a year in income, you would need to have $2 million saved.
The rule emphasizes the need to amass a lot of money, and not to overspend from the savings pool, but market fluctuations and spending vagaries could make this wildly inaccurate. What’s more, this roughly assumes that the retiree gets to remove whatever the portfolio produces in a year, which doesn’t work in environments where the market is down and takes all portfolios with it, or when inflation, taxes or other variables kick in.
6. The stock market will give you a 10 percent annual return over time.
This is a fuzzy interpretation of the famous Ibbotson-Sinquefield stock market study, research which showed that stocks deliver an annualized average return of 10 percent. The problem is that Roger Ibbotson, the guy behind the study, has been saying for about a decade now that the next 25 to 50 years won’t be like the 75 that were the crux of the study, suggesting that returns will be closer to 8 percent annualized.
Moreover, the 10 percent number includes several assumptions, such as a long time horizon — no active trading — no taxes and no transaction costs. Academics get to ignore those things, but consumers don’t; factor taxes and commissions and other things in, and the long-term return would be closer to 9.5 percent.
Also, many people forget that the historical returns are an average, not an annual total. When people live by this rule, they are easily scared whenever the market falls short of the mark.Chuck Jaffe is senior columnist for MarketWatch. He can be reached at email@example.com or at Box 70, Cohasset, MA 02025-0070.