Wednesday, August 20, 2014

Test Driving Financial Rules of Thumb

Taking a close look at some financial rules of thumb began with a post at Brighter Life and jumped to My Own Advisor. Here I give my take on some very common rules of thumb.

Your retirement income needs to be 70% of your working income.

This is obviously just an average or typical case. You should really look at you spending needs, including saving up for bigger items like replacing a car, windows, furnace, flooring, or roof. My family’s spending is currently about 40% of the combined take-home pay for my wife and me. It makes no sense for us to target a retirement income almost double what we need right now. Retirement needs are driven by your spending, not your income.

Keep an emergency fund equal to six months’ income.

I’m a big believer in liquidity. Access to credit may seem like adequate protection, but lenders may take away access to credit in tough financial times. If you lose your job when the biggest employer in town goes bankrupt, banks may not be in a hurry to lend to you. If you can borrow, the rates may be painful.

Exactly how much you need in emergency savings depends greatly on your flexibility. How much can you reduce spending? Are you able to take a job that you could get quickly but may pay less? Are you able to move to find new work? I tend to have 4 to 5 months of spending in cash. Very flexible people may need less than this and others may need more.

Don’t pay more than 3.5 times your gross annual income for your house.

This seems far too high to me. I’d much sooner rent than spend this much for a house. At current prices, it’s certainly possible to rent a nice house for much less than it would cost to own the house. As long as you’re saving the difference, renting can be much less risky.

Don’t invest more than 5% of your savings in any one stock or bond.

This is sensible for stocks and for bonds that have risk, but makes little sense for Canadian government bonds. I actually violate this rule in my own portfolio. I still have about 10% of my savings in Berkshire Hathaway stock. The large built-up capital gains make me hesitant to sell and pay the taxes.

Accumulate 20 times your gross annual income, then retire.

I don’t see the logic of basing retirement goals on my current income. They should be based on my spending. Using this rule, I get further from retirement every time I get a raise. I can just imagine a worker flying into his boss’s office in a rage: “what’s this raise garbage? My savings were up to 19.5 times my pay. I was going to retire in 6 months. Now I’m down to 18 times. I’ll have to work another 2 years!”

Never touch your retirement savings, except for retirement.

Apart from extreme circumstances, this is a sensible goal.

In retirement, you can sustainably live off of 4% of your starting nest egg, rising with inflation.

There is research that supports this rule of thumb. However, it is based on the assumption that you pay no investment fees. If you’re like most Canadians who own mutual funds and (often unwittingly) pay substantial MERs, the safe withdrawal rate is much lower – more like 3% as I showed when I repeated the research to include the effect of fees.

If your employer matches your contributions to a workplace savings plan, go for it.

This is good advice. One thing to watch out for is that if you are forced to invest in company stock with all or part of the money, you should sell out of that stock and buy something else when possible. There are so many examples of companies going bankrupt and employees losing both their jobs and their savings. Like those employees, you may think that your company can’t go out of business. Those companies went out of business and so can yours.

The percentage of your portfolio in bonds and fixed-income investments should be equal to your age.

This is safe enough, but I find it too simplistic. I prefer to put all savings I won’t need within 5 years into stocks. But this isn’t for everyone. A huge potential risk for all investors is the possibility that they’ll lose their cool during a stock market crash and sell low. The 2008-2009 crash was a good test of your ability to stay invested. If you sold stocks back then, even if you think it was for a smart-sounding reason, you may need to keep your stock allocation lower. Even if you just failed to rebalance from bonds to stocks during the crash, your stock allocation may be higher than you can really handle.

Total home ownership costs shouldn’t exceed 30% of your gross income.

This sounds too high to me. As I wrote above, renting is not a bad option when house prices are high.

Your total debt servicing costs shouldn’t exceed 40% of your income.

Again, this sounds far too high to me.

Don’t plan to retire with debt.

Yes.

You need to have x times your annual income in life insurance.

This is far too simplistic. As your savings grow, your need for life insurance tends to drop. I have far less life insurance now than I did 15 years ago even though my income is higher now.


If there’s one theme running through my reactions to these rules of thumb, it’s that you should think. This shouldn’t be too hard for my readership, but too many people prefer to be told what to do.

3 comments:

  1. Solid answers Michael. Personally, I was shocked by the 3.5 times gross annual income for a house. I can't imagine that.

    10% in Berkshire is a pretty good play, I suppose it's OK you made this exception :)

    Mark

    ReplyDelete
    Replies
    1. @Mark: Thanks. I have no plans to buy more Berkshire, and I'll likely sell it at some point.

      Delete
  2. When I got divorced and "re-bought" the house @ 14% mortgage along with child support payments I was at approx 75% of my take home pay. Never understood why the bank lent me the money but the house is mine now and the kids are all working so no child support expenses.
    As to retireing debt "free" I'll have to think that one over. I have a 100K LOC @ 3% interest that with re-investments of dividends and lucky stock picks is paying me over $9K in divs per year. So I am getting $6K of taxable divs for "free" every year. The divs go to pay down the LOC (I do not spend them). SO over time the LOC diminishes as well as the interest charges and if a stock comes up on the radar that I like then I utilize the LOC to invest in more stock.
    SO when I retire that will be my first line of funds as I draw down on it to 1) shunt money to the TFSA every year so it really becomes tax free 2) Sell off the losers first so that the later sales will have some capital losses to be utilized 3) Eventually pay down the LOC
    After that I will have to convert the RRSP's in to RIF's but at least I will have gained several years before I have to touch them.

    That's my plan for now

    ReplyDelete