Personal finance is full of rules of thumb.
They can be helpful for DIYers, but most of the time, they’re just noise.
Here are a few common examples with some added context to help you understand whether you should pay attention to the rule, completely ignore it, or adjust it for your situation.
Spoiler Alert: Most of this boils down to one thing - you should probably consult a financial planner to help you understand what makes the most sense for your specific situation.
The 4% Rule
This rule originated from a study in the 90s by an advisor named Bill Bengen. He looked at 50 years of stock and bond returns to try to figure out a safe withdrawal rate - that is, a percentage of your portfolio that you can withdraw each year without significant risk of running out of money.
It’s important to understand - the 4% rule doesn’t mean that you would take 4% out of your portfolio every year. It really just indicates a starting point from which you’d adjust your withdrawals for inflation.
Here’s the idea: Say you have $1,000,000 when you retire. In year 1, you withdraw $40,000 to live on. That year, the inflation rate was 2%, so in year 2, you withdraw $40,000 PLUS a 2% inflation adjustment (or $40,800).
What Bengen found in his research was that even in the WORST of times, the portfolio wouldn’t be depleted in the first 33 years.
Here are the issues with this rule:
It doesn’t account for taxes
It doesn’t account for when you draw Social Security or other retirement income
It doesn’t account for adjustments YOU make if it’s a bad year for withdrawals
It assumes a portfolio that isn’t for everyone
If you’re young and feel like you need a target amount of money to retire on, you can use the 4% rule to come up with a target by taking your current expenses and multiplying by 25 - but recognize that the number will need to increase with inflation.
Check out this Investopedia article if you want to learn more.
The “100 Minus Your Age” Rule
This one is intended to help people understand how aggressively to invest. How much of your portfolio should be in stocks? Well, take 100, subtract your age, and voila!
According to this rule, if you’re 60, you should have 40% in stocks. And if you’re 20, you should have 80% in stocks. Ridiculous.
With the emergence and rising popularity of target date funds, less people have been asking this question, but it does still come up. Target date funds start out aggressive and are managed to get more conservative as the “target date” approaches.
The Vanguard Target Retirement 2060 Fund (VTTSX) is currently about 90% in stocks and 10% in bonds.
The Vanguard Target Retirement 2030 Fund (VTHRX) on the other hand is currently about 60% in stocks and 40% in bonds.
In 30 years, the 2060 fund will look a lot like the 2030 fund looks today.
Target date funds do a better job of solving this problem than the “100 minus your age” rule, but I still have some issues with them.
The rule and the funds both have the underlying assumption that everyone is the same
Neither take personal risk tolerance or risk capacity into account
Both are intended for retirement (in most cases), so they ignore saving and investing for pre-retirement goals
In the case of target date funds, every provider operates differently - here’s the allocation of a few 2040 funds from different providers (denoted as stocks/bonds):
BlackRock (LIKIX): 70/30
Vanguard (VFORX): 75/25
American Funds (AAGTX): 80/20
Schwab (SWYGX): 80/20
Fidelity (FFFFX): 85/15
Please note that these are all subject to change and WILL change over time. Not a recommendation to purchase any of these funds.
Conclusion
You probably realize by now that I’m not a huge fan of rules of thumb. I don’t even like to use them as a starting point - it feels like an affront to the individuality of the people I’m working with.
Here’s what I do for the people I work with instead of using rules of thumb.
We discuss your current situation:
Living expenses
Current savings rate
Current assets/liabilities
We discuss the things you’d like to spend money on in the future along with future income sources
We utilize planning software (I use RightCapital) to run a Monte Carlo analysis - this helps us determine how feasible your current plan is without any adjustments
We build a portfolio using the “bucketing strategy.” Near-term funds are invested conservatively, mid-term funds are invested in a more balanced approach, and long-term/legacy funds are invested more aggressively.
Want to start the process to do some planning and improve your portfolio? Take 10 minutes to fill out your profile in RightCapital by clicking on this link.
As always, keep in mind that you don't have to go it alone. I’m Austin Preece, a financial planner in Eau Claire, Wisconsin, and I work virtually with people across the US. Check out my website to see what it's like to work with me and reach out if you have any questions.
If you found this post helpful, help spread the word! Share with friends and family that you think may benefit as well. But remember, this is solely for educational purposes - it's not advice.
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