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Fistful of Trouble

Jonathan Clements  |  March 26, 2016

CONFRONTED BY a complicated financial world, the temptation is to fall back on rules of thumb. But are these rules any good? Here are five of the most popular:

1. Save 10% every year. There are two knocks on this rule of thumb. First, the 10% of pretax income is the sum you’re meant to save for retirement—which means those who have other goals, like buying a house and paying for a child’s college education, need to save even more. Second, even if your only goal is retirement, you probably ought to be saving 12% to 15%, given today’s modest bond yields and heady stock market valuations. And if you don’t start saving for retirement until after age 35, you likely need to save a whole lot more than 15%.

2. Buy life insurance equal to five to seven times income. This is probably the most dubious rule listed here. If you’re single with nobody who depends on you financially, you likely don’t need life insurance. If you have three young kids and not much in savings, you might need twice as much coverage as this rule suggests—and possibly far more.

3. Set aside emergency money equal to six months of living expenses. If your job is tenuous, this isn’t a bad benchmark. But for those with more secure jobs, a spouse who works or access to a home-equity line of credit, an emergency fund equal to three months’ living expenses might suffice.

4. In retirement, you need 80% of your final salary. This is a tough threshold to hit. The good news: You’ll probably be just fine if—between Social Security, any pension income and portfolio withdrawals—you manage 50% to 60% of your preretirement income. Why? Once retired, the mortgage might be paid off, the kids have moved out and you don’t have to pay Social Security payroll taxes. Most important, you no longer need to save for retirement. Lots of folks make a big push to save in their final years in the workforce, notching a savings rate of 20% or more, so they’re already used to living on far less than their full income.

5. Limit your retirement withdrawal rate to 4%. The idea is to withdraw 4% of your portfolio’s value in the first year of retirement and thereafter increase your annual withdrawals with inflation. Studies have found that, historically, this would allow retirees to make it through a 30-year retirement without running out of money.

Lately, the 4% withdrawal rate has been criticized as too generous in a world where stocks and bonds are so richly valued. That may be true. Still, advocating anything less is unrealistic, because people simply couldn’t afford to retire. My advice: Start at 4% or even 5%—but stand ready to slash your spending if the markets go against you.

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