Four Thumbs

Adam M. Grossman

EVERYBODY WANTS easy answers. But often, things aren’t so simple, especially when it comes to financial conundrums. Consider the four common money questions below—and the rules of thumb that folks frequently rely on.

1. How much do I need saved for retirement? Type this question into Google and most of the answers will recommend that you save some multiple of your income. Some suggest eight-to-10 times income, while others recommend as much as 25 times.

My take: A better way to think about retirement savings, I believe, is to focus on your expenses, not your income. Why? When you’re in your peak earning years, you are likely making much more than you spend. Suppose you earn $200,000 per year. You might spend just $120,000, with the balance going to taxes and savings. In that case, you would need to focus on replacing only $120,000 in retirement, not $200,000.

There are two reasons for this. First, once you’re retired, you don’t need to save for retirement. Second, as I have pointed out before, your tax rate may be much lower once you stop working.

On top of this, your expenses could decrease sharply in retirement. Your children may be out of college and your house might be paid off. In addition, you’ll probably have extra income, in the form of Social Security. Put it all together, and you’ll likely end up with a far different target nest egg than if you focused simply on replacing your income.

2. How much should I have in stocks vs. bonds? We’re often told our portfolio’s percentage in stocks should equal 100 minus our age. For example, when you are 30, you should have 70% in stocks, but when you’re 70, you should have just 30% in stocks.

My take: There is some logic to this rule of thumb. For most people, it does make sense to take less risk as they get older. Still, we need more than a one-size-fits-all formula. Let’s say your assets are substantial relative to your spending needs, or you have a pension, or you work part-time in retirement. These are all reasons you might choose to take more risk than somebody your age who doesn’t have these same resources. The upshot: I would disregard this rule of thumb and instead structure your investment portfolio around your own individual income needs, regardless of age.

3. How much life insurance do I need? Many employers provide coverage equal to some multiple of your salary, generally between one and five times your pay, and lots of people assume that’s enough.

My take: Your current pay is a poor guide to your family’s total financial needs. In fact, your life insurance needs might actually be inverse to your income. If you are early in your career and have a young family, that’s when you’ll want to have the most insurance—to pay off student loans and the mortgage, and to cover ongoing living expenses and college tuition.

Meanwhile, as you progress in your career, you will likely need much less insurance. That’s because some of those large expenses will be behind you, and also you will have accumulated savings along the way. This is sometimes called becoming “self-insured.” Once you reach that point, I think you can drop your life insurance.

By the way, this dynamic of becoming self-insured over time is another reason I recommend only term life insurance and never whole life. Except in rare cases, you just don’t need insurance for your whole life.

4. How much disability insurance should I have? Disability insurance is typically capped at 60% of your income, so that’s what folks often default to.

My take: On the surface, the purpose of disability insurance is similar to that of life insurance. If something were to happen to you, you would want insurance to help pay the bills. But there is an important difference: Disability insurance doesn’t provide a lump sum. Instead, it provides the equivalent of a monthly paycheck and, with most policies, those checks stop around age 65.

For that reason, in calculating how much coverage you’ll want, you need to include three components: your family’s regular household expenses, major future expenses such as college tuition, and your need to save for retirement. Of these, the need to continue saving for retirement is often overlooked.

One more thing: Be sure to understand who is paying the bill for your disability coverage. It might be you, it might be your employer or it might be your employer with the premiums imputed as income to you. That makes a huge difference: If you didn’t pay the premiums—either directly or indirectly—any benefits you receive will be taxable. If you end up disabled, that could have a big impact on your family’s standard of living, depending on your family’s total income and hence what your tax bracket is.

Adam M. Grossman’s previous articles include Looking SharpeAnything but Average and Losing It. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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