Rules of Thumb are Sometimes Dumb

Justin Hooper conveys ‘the importance of personalising rules of thumb’

I was reading an article this week about how much retirees need relative to their previous earnings. According to the article, the right amount is 70-80% of pre-retirement income. It’s not the first time this number has been used – but is it correct, and where does it come from?

In my experience and the reading I’ve done, the estimated range is enormous. In one research report I read, respondents were asked to outline the lives they wanted in retirement irrespective of what they were earning. Turned out that on average they needed 130% of pre-retirement income. I suspect that the rule of thumb on how much one needs in retirement has come from how much most people have accumulated, not what kind of lives they really want.

Often, the conventional wisdom creates an incorrect target and ironically then becomes reality which reinforces the rule. It got me thinking about “rules of thumb” — which ones are valid, how to use them, and some that I have created.

Rules of thumb are meant to be broadly applicable, but when handed down as the wisdom of elders they can be very dangerous.

Don’t just accept them
At a Christmas lunch one year, a young girl asked her mother why she cut the ends off the pork roll before putting it in the oven.

“That’s what my mother taught me to do,” mum said. “She’s here, so let’s go and ask her.”

“When I got married, we didn’t have much money and I had to use the same pan for everything,” grandma explained. “The pork roll was too big for my pan so I cut the ends off it.”

Rules of thumb emanate from the practical insights of others. Most (particularly older) people will have developed some during their lives and many are adopted from parents. They’re supposed to provide guidance; they’re not based on scientific study. They’re applicable broadly and can be useful, but there are always exceptions.

Hard to ignore when expounded by an ‘expert’
At one time in my career, I worked alongside an adviser who was previously an actuary. In my mind, my actuarial colleague had an aura of authority about him which meant that his rules of thumb were accepted without question – for a while. One of them was how much insurance people needed.

“Thirteen times their annual expenses,” he said. It took me a while to challenge this and when I did, I found very little substance behind the rule.

At another time in my career I briefly worked for a company who had as one of its directors a big finance media personality. The rules of thumb he expounded around retirement were also wrong (in my view, anyway). Retire at 55 and you need 17 times your annual expenditure, 15 times at 60 and 13 times at 65.

For these to be accurate, you would need to assume that you definitely don’t live beyond your life expectancy and the returns on your portfolio are better than average over your particular time horizon. And that’s another one that’s dangerous – planning to your life expectancy. There’s a 50% chance of living beyond your life expectancy, so planning cash flow to then has a 50% chance of failing

Question the rules
Rules of thumb cannot be implemented without question. Here are some that are worthwhile but nonetheless have flaws.

The 10% rule: Always save 10% of your salary. Doesn’t take into account when you started, what return you will get, and what kind of life you want at the end.
The 50/30/20 rule: 50% of your income goes to necessities, 30% to financial goals and 20% to choices. Depends on your stage of life. The ratios need to be adapted to different stages of life.
The 20/4/10 rule: When buying a vehicle, put down 20% as a deposit, pay it off in 4 years and don’t spend more than 10% on transportation costs. Don’t buy a vehicle you have to finance.
The 20% rule: ‘Put down a minimum of 20% as a deposit on a home’. Depends on your income relative to the cost of the home.
The Six-Month Emergency Fund Rule: ‘Have at least six times your monthly expenses in an emergency fund’
The amount of life insurance you need is five times your annual salary. Depends on the level of other assets and income.
‘100 less your age is the percentage of shares you should have in your portfolio.’ Depends on total assets relative to income required and emotional risk profile.
Here’s one that people in other countries apply and Sydneysiders will laugh at: “The cost of your home should be no more than 2.5 times annual income.”

My rules of thumb
I’ve come up with a couple of my own that I use daily.

How much is enough? 20 times your annual expenditure, (assuming you have a maximum 35-year time horizon). Another way of looking at this is double your lifestyle assets — you need twice as much in investments as the value of your home.
Changing home. Every time you sell your home and buy another, it costs one year of work. Here’s my theory – the costs of selling a home are 4% stamp duty plus around 2% commission to the agent – all after tax. That’s equivalent to around 10% pre-tax, and for most people, their annual income is around 10% of the value of their home.

Personalise rules of thumb to make them useful
The value in having rules of thumb is that they provide a benchmark that’s easy to remember. And there’s no doubt that having a benchmark influences behaviour. At the same time, for it to be believable, it needs to be personalised. Take the basic rule and tweak it to suit your purposes. Then apply it.