Among the most common tips you read in personal finance are rules of thumb. The 4% spending rule, the 80% retirement income rule, the snowball debt repayment rule, the 10% saving rule, the 50/20/30 budgeting rule, and the list goes on. Do they work? Well, what do you think?
Let me answer with an example. You may have heard to eat lots of pasta the day before a running or cycling race. But what if you are gluten intolerant? How do you think that would work out for you?
I love simple rules, there is some wisdom in them, if you understand the why behind the results. They simplify complex problems and are relatively simple to follow. But have you heard of anyone that consistently sticks to a bunch of these rules and get to where they want?
Just like the pasta example, if a rule isn’t designed for you, you are going to experience problems down the road, and even sticking to it will not lead you to where you are trying to go. We have tested some of these rules in previous research. The bottom line is that it’s not hard to find examples of failures even after strictly following them.
It’s not the simplicity of the rules that is bad, it’s that we are typically not equipped to adapt them to our situation. Rules are normally stated in terms of average prescriptions. But no one is average. If we don’t know the assumptions made to arrive at the prescription, we don’t know how to change it to fit it to our particular case. The result is that, if blindly applied to an individual, rules go from being close enough for a minority of people, useless for most, to possibly harmful for some.
Make it personal
So how can we make a plan or a rule work for us? You guessed it: You have to make it personal. Think of it this way. Your plan is made of three things: your goals, your starting point, and the path that connects the two. How you choose any of these is personal. Only you know your destination. What does retirement look like to YOU? And what tradeoffs are YOU willing to make given the resources available to you, including your money, your time, your skills, and your energy? Typically, your age, stage of life, current financial situation, preferences, and your behavior all matter in how you choose.
Stage of life and behavior matter
Your age and stage of life matter to how you answer these questions. If you are just starting out, it’s almost impossible to figure out what your retirement goal is, and you have many competing needs. So the goal is a secondary part of the plan. Save as much as you reasonably can. How much is reasonable is a personal choice, and your behavior towards money can result in different answers. Say you have sizable student loans. It may be OK to just make minimum payments on them if the rate is reasonably low, and if that helps you save more for retirement. Your rule could be save 6% or 8% of your income, if those are reasonable rates for you. But some people only get the first part of the advice, and end up overspending and not saving in their retirement accounts. For people that find it hard to commit to a saving habit, paying off their loans faster and saving just enough to maximize the employer match could be a better option.
When to set a goal
If you have a more established family, you can start by setting a goal. A common rule says that you should replace about 80% of retirement income. But a better approach is to start by looking at what YOUR needs might be in retirement. Consider current expenses and needs, and take out all the items that you may not have in retirement. Items can include saving for retirement and your kids’ college education, your mortgage payments, your business suits, and may be more. The extra time that comes with retirement can also lead to savings, as you can look for deals and do more things yourself. There may be costs connected with retirement, like supplemental health and term life insurance, so you may want to consider if those apply to you. Once you have a goal, even a rough one, you can figure out how much you need to save for it, and what savings vehicles you may rely on. For some, social security and their 401k account will cover their needs. For others, the withdrawal plan can include IRA and Roth accounts, a private pension, annuities, or other personal savings. When you compare your goals to your savings, you may find your goals aren’t realistic, or that you can do more than you expected, a nice morale boost. If you can’t save enough, you need to think about retiring later, or review your expenses to see if you can reduce your needs in retirement.
Consider your key risks
Your risk attitude should matter to your plan too. Risk tolerance questions are usually used to determine your investment mix. But there is more to risk than that. Risk is also about what scenarios you want to avoid or minimize. What is the absolute minimum you can live on in retirement? Would it make sense to buy an annuity to cover these expenses? What type and how much insurance do you need? How will your family cover their needs if you can’t work? How will you cover potential health care costs, including long term care? Typically, young households emphasize life and disability insurance, while older ones emphasize health and term insurance. What is your need? These are all personal questions.
How to get started
Our advice to you is before sticking to any rule, consider if it makes sense for you, and how you may adapt it to your particular case. We tried to give you a few things to think about here, and follow our blogs over time for more tips. If you are not sure what to do and wish you could talk with an expert, you should do so. For most people, creating a personal plan is best done with a financial planner. And now you know how to pick a good one. Your planner can’t simply hand you a prescription, they need to create a personal plan for you.
A good planner is akin to a good doctor. How would you feel if your doctor asked you a couple of leading questions, quickly diagnosed you, and sent you away with a prescription? I am sure you prefer a doctor that listens as you try to explain your symptoms, that wants to know your history, your habits, and your health and fitness aspirations. Only this way the doctor has the information to complete a diagnosis and a plan to get you better. So run if you feel your advisor or planner isn’t listening; the first trait of a good financial planner is listening skills.
Until next time!
Massi De Santis is an Austin, TX fee-only financial planner. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.