Loading ...General rules of thumb for financial planning rarely work. Here are some that you may have considered, with my critiques. (If you want more analysis, please let me know.)
“Stocks minus your age should equal 100” – Bad rule – your investment allocation depends on your risk tolerance, the rate of return required to achieve your goals, when you add to investments from annual savings or stock option exercises and when you remove investments to fund lifestyle needs.
“Life insurance must equal six times compensation” – Bad rule – we look at all of your resources, including insurance, and compare their earning ability to your lifestyle needs. This identifies the short-fall to be funded by insurance, which can be more or less than the six-fold multiple but ensures that your survivors have adequate resources to be protected. N.B. – long-term policies may not be available after this year so you should review your insurance needs now.
“Save 10% of income annually” – Decent rule – however, some may need to save even more and others may have no savings need. As with the life insurance analysis, the question is whether the return from assets plus annual savings over your life expectancy will fund your lifestyle.
“You only need 70% of income in retirement” – Bad rule – in fact, many people spend more in the first years of retirement as they travel more while spending far less in their 70’s and 80’s as their needs become fewer. This can be further complicated by estate planning goals of gifting to children or charities.
“Hold six months after-tax income for a rainy day” – Decent rule – however, this depends on liquidity, borrowing ability (e.g., home equity line) and cash flow. If annual income permits substantial savings, such that you could pay for a new roof without affecting lifestyle, your “rainy day” reserve can be much less.
“Monthly payments on debt should not exceed 20% of income” – Decent rule – in fact, the rule is somewhat irrelevant in that most lenders apply rules to limit mortgage payments plus home insurance and property taxes to a percentage of income. As with the savings rule, your level of debt may be more or less depending on assets available, risk tolerance and lifestyle costs.
“Do not refinance until rates drop 2%” – Bad rule – the test is simply one of how soon the costs of refinancing are recouped by lower payments. With no points/no closing cost loans, this can be immediately. Buying down a rate by paying costs or points will make sense if the pay-off is in 12 to 24 months and if you plan to stay in the residence for three years or more.
“Delete collision coverage on a car more than 7 years old” – Decent rule – as with the “rainy day” reserve, this depends on cash flow and other resources. It also depends on whether the car is your “antique.”
“Do not spend more than 7% of income on long-term care insurance” – Uncertain rule – some people may have sufficient assets to self-insure. Other people may see the risk of nursing care as great based on family history so that they will want to pay for the insurance.