We love to have rules of thumb to guide us. They are designed to give you a rough idea of what to aim for so you can get started on your goals. A rule can sometimes help make decisions easier. However, it likely will not give you an accurate answer for your own personal situation and, indeed, some rules of thumb have become outdated.
Here are five rules of thumb that could use an update:
Save 10% of your gross income
The problem with this rule is there is no context. Are you saving this for retirement? Or, in addition to retirement savings?
Most current employees will no longer enjoy a defined benefit pension when they retire. In order to reach retirement goals a saving rate of 15% or even 20% may now be necessary. First take advantage of any company pension matching programs, then top up.
Savings for other goals – emergency fund, house down payment, child’s education, vacation – depend on the amount you will ultimately need and your time frame, so saving 10% of your salary may or may not allow you to reach your particular goal.
Your retirement income needs to be 70% of your employment income
In a report prepared last year for the C.D. Howe Institute, Malcolm Hamilton debunked the widely accepted maxim that people need 70% of their pre-retirement income to maintain their standard of living, saying it’s possible to live comfortably on less (50 – 60%).
This rule focuses on income – not expenses. It’s what you spend that matters.
First you need to identify which expenses will disappear when you are no longer working. Then, consider the lifestyle you want and what it will cost. Retirement could be on the costly side (extensive travel) or on the frugal side (staying home and watching TV).
Your needs in retirement should be based on spending, inflation, your health and life expectancy, not previous salary.
Home expenses should be no more than 32% of your gross income
This figure is the Gross Debt Service ratio (GDS) your bank will use to determine your maximum mortgage amount. It includes the mortgage payment, property taxes, heating (and 50% of condo fees). It does not include home insurance, other utilities or any maintenance costs. If the mortgage amount is based on two salaries, what happens if one of you stops working?
Contrary to this popular guideline, your total home ownership costs probably shouldn’t exceed 30% of your gross income, and some advisors would even reduce that to 26% or 28%.
Keep an emergency fund equal to 6 months’ income
Here again, the focus is on income instead of expenses. If you lose your job, for example, you should be able to cut any extracurricular expenses to the bone, (as well as any savings programs).
Three to six months’ worth of your necessary expenses would be a more accurate figure. Also, no credit card debt and having access to a line of credit would help in a short term emergency.
Subtract your age from 100 to determine your stock allocation
This rule worked better when bond yields were higher. Now, if you’re retired and you depend on this income, you may not be earning enough and may face a shortfall if investments underperform.
Advisors now think that may be too conservative and the number should be readjusted to 130 or 140. Consider your risk tolerance and such factors as lifestyle needs, probable life expectancy and whether or not you have a strong pension.
It’s more accurate to devise your own rules of thumb based on your goals and needs.
They may be as simple as “I don’t pay more than $65 for a pair of jeans,” or as complex as your personal Investment Policy Statement.
You are not the same as everyone else – you shouldn’t be strictly following a general rule.