Financial planning often is too complicated, and personal, to rely on generalizations. Still, certain rules of thumb that are easy to grasp can provide insight when it comes to saving, investing, debt and more.
But are they worthwhile and even realistic? That depends. Here are some common examples:
Buy homes worth no more than 2.5 times what you earn
There are various rules of thumb related to housing. If you're looking to make a purchase, this one suggests that you shop for dwellings priced no more than 2.5 times your annual income. So if you earn $100,000 annually, you would look for homes in the $250,000 price range.
This rule is simplistic, as a lot of factors other than price factor into the equation, such as how much you need to borrow, what your monthly expenses will total, whether you could deduct housing costs on your tax return and whether you have other assets on the side. It also ignores the level of interest rates and thus mortgage costs.
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In the current low-rate environment, your housing dollars will stretch a lot further.
An article in Bankrate.com suggested the 2.5 times rule, but Greg McBride, chief financial analyst for the website, doesn't adhere to it strictly.
"The ceiling I’ve always recommended is not to buy a home costing more than three times your annual income," he said. Adhering to the 2.5-times rule is more conservative, but it also might limit your choices in pricey or hot housing markets.
Still, the spirit of the rule is sound, McBride said. It's about "calibrating how much you pay for a home" so that you don't overspend and saddle yourself with payments that you would struggle to afford.
Save enough to cover three months of expenses
It's common to hear financial advisers recommend that you save at least this much. Some even suggest saving an amount equal to six months of expenses, which would provide even more cushion in case you lost your job or suffered other setbacks.
And there are other variations of this rule of thumb, such as striving to save 10% or even 15% of your gross pay. In short, there's no single rule of thumb on saving.
The problem is many Americans struggle to save anything, so even the more modest goals cited above could be a stretch.
An estimated 53% of Americans don't have any savings to meet unexpected car repairs or other emergencies, according to an October report by the AARP Public Policy Institute. That's an even higher proportion of non-savers than other studies have shown.
Savings issues plague people in all age groups, and at least one in four households earning six-figure incomes lack emergency savings too, the AARP study found.
Clearly, the savings obstacles can be so daunting that plenty of people give up before they start. But they shouldn't. Scottsdale financial adviser George Fraser at Retirement Benefits Group in Scottsdale provides guidance for workers in 401(k) plans. He suggests framing the challenge in terms of pennies on each dollar of income – start with that first penny, then build up from there.
The three-month savings rule is a good target, but it's unrealistic for a lot of people.
Invest 100% minus your age in stocks
Assuming you have enough money to invest, this is another rule to consider.
The idea is to apportion or allocate your portfolio broadly between stocks/stock funds, on the one hand, and bonds/bond funds/cash on the other, so that you balance risk and reward for your stage in life. Stocks provide more growth potential but come with enhanced risks. Bonds deliver lower returns but provide a cushion against sharp losses.
That's where 100% minus your age comes in. If you follow this rule, your investment posture would start out aggressive and grow conservative over time.
For example, at age 25, you would hold 75% in stocks/stock funds and the rest in bonds/cash. At age 75, the figures would be reversed. This approach underlies the rationale behind target-age mutual funds, which are used as default choices in a lot of 401(k)-style plans, when people don't make their own selections.
The rule doesn't fit every situation. For example, older investors drawing a pension and Social Security with a paid-off mortgage could afford to be more aggressive, especially if they're looking to bequeath some of their assets. Conversely, a young adult just starting out first needs to build up a cash reserve, which is conservative, before making big stock-market bets.
The rule also could be too conservative for retirees who expect to live to a ripe old age. One modification would be to hold 110% minus your age in stocks, which provides more growth potential and long-term protection against inflation.
Keep withdrawals to 4%-5% annually
This rule of thumb focuses on what is considered a sustainable portfolio withdrawal rate. The notion here is that if you limit annual withdrawals to 4 or 5% of a portfolio's worth, the portfolio will hold its value, more or less. If you go above that– pulling out 6% or more– you could start eating into the principal significantly.
This rule of thumb rests on the assumption that you hold a balanced portfolio that includes a sizable mix of both stocks and bonds. It furtherassumes you are taking out money during periods when the stock market is rising, or at least stable. Instead, if you pulled out even 4% during a year of sharp losses, your portfolio might not easily recover.
In a study, Fidelity Investments suggested that Americans entering retirement withdraw no more than 4.5% of their savings each year if they hope to keep their nest eggs intact. So if you have $500,000 saved up, you could safely withdraw about $22,500 yearly, supplemented with what you get from Social Security.
Plan to replace 70% of your income in retirement
Financial planners talk about the need to replace a certain amount of your work income when you retire, if you hope to maintain the same lifestyle. Many studies suggest aiming for a "replacement ratio" of between 70% and 85% of pre-retirement income, according to a recent paper by the Vanguard Group.
So,if you earn $100,000 while working, you'd want to generate $70,000 to $85,000 or so in retirement income. You calculate this ratio by starting with current annual expenses, then factor in likely changes upon retiring such as those affecting taxes and health-care costs.
Many personal variables affect the calculationincluding marital status, income, your health, the value of retirement accounts owned, and housing costs. You also should factor in significant retirement changes such as downsizing or moving to a less-pricey area.
Conversely, if you plan to travel a lot or take up expensive hobbies,that could boost your expenses in retirement.
The Vanguard study didn't really support or refute a replacement-ratio range of 70% to 85%. Rather, the paper offered suggestions for fine-tuning it to personal circ*mstances. If those percentages seem high, remember thatSocial Security income can help meet the goal, supplementing personal savings and any pension coverage you might have.
But if you're relying solely on Social Security, prepare for a less lavish lifestyle ahead.
Reach Wiles at russ.wiles@arizonarepublic.com.
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