Research suggests that you should multiply your income at certain ages by your savings factor to see how much you should have saved by that point to feel that you will be able to retire comfortably.
Amy is a 40-year-old woman in Mercer Island who has based her retirement strategy on “the golden rule my father taught me when I got my first job.” That rule — “Save 10 percent of your gross income” — has been the core of her financial plan for two decades.
And then she read my column two weeks ago, saying that investors were misguided by financial rules of thumb, that they are a one-size-fits-some solution.
“Now my husband and I aren’t sure if we are saving too much (it’s hard for us to save that much) or too little,” Amy wrote in an email. “What’s the right amount?”
The problem in that question is that answering it in this forum means endorsing another rule of thumb, and since we know that those don’t work universally — a big reason why many people need a financial adviser to help them — I’m reluctant.
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But most rules of thumb are guidelines, passed down over generations, so if there is a good alternative to the generic “Save 10 percent of your gross income” it would be the “savings factor” developed by Fidelity Investments a few years ago.
That research suggests that you should multiply your income at certain ages by your savings factor to see how much you should have saved by that point to be comfortable that you will be able to retire comfortably.
The savings factor starts with one times your salary saved by age 30, and then goes up by one multiple every five years — so that a 35-year-old should have two times his or her salary saved, and a 40-year-old should have 3X and so on — up to age 60. At 67, Fidelity posited, an individual should have 10 times his or her salary saved.
So to answer her question, Ann can see if her 10 percent set-aside has been the right track by determining if she and her husband have saved three times their income. (It’s important to note that Fidelity assumes individuals are saving 15 percent of their income, investing more than half of their savings in stocks over their lifetime, and that they plan to maintain their pre-retirement lifestyle for at least a year in retirement.)
The Fidelity research is an improvement to another rule of thumb too, the one which says that your investments must generate 70 to 80 percent of the income you receive while working. The fund giant suggested that investors need to replace 85 percent of their final income, although they include Social Security as part of that replacement.
That’s a step-up on two more financial rules of thumb, but readers asked about other old saws as well. Here are a few more rules that investors and savers told me they use and wondered about:
• One-third, one-third, one-third: Set aside roughly one-third of your total earnings to cover taxes, another third for living expenses and the rest for savings.
As guidelines go, this is catchy and memorable. In real-life application, it’s sloppy. Its success is more likely dumb luck than sound thinking.
This is a Goldilocks rule, meaning it’s hard to find it fitting just right. If your earnings are high, you’d be overspending; if your income is low, you might not be saving enough. It’s also so hard for people to set aside more than 30 percent of their income that many people will simply find this impossible to live by.
There’s also the problem of how difficult it is for most people to actually set aside more than 30 percent of income into savings, making the input on this rule more unreliable than the outcome.
• If you can live on less than 5 percent of your savings amassed when you hit retirement age, you will not outlive your money.
The good thing about this rule is that it forces you to think about what you could live on, and then to save enough to generate that income. If you believe you can live on $50,000 a year to live comfortably in retirement, then you need $1 million in savings.
With conservative returns and reasonable market conditions, that would give you a good chance to live off your interest and gains without eating much into the principal. But sequence-of-return risk — where the market tanks and hurts your portfolio at the beginning of retirement — and spending vagaries could make this rule wildly inaccurate. It might be perfect for one generation — which is why your parents told you about it — and awful for the next.
• Keep three to six months of salary in an emergency fund.
This rule is flawed, because disaster-preparedness savings should focus on living expenses, rather than gross income.
Your emergency fund isn’t there to replace lost paychecks; it’s supposed to pay the bills. Moreover, the need for emergency savings varies by circumstances, including disability insurance protection, the availability of credit and the potential costs a family would face from a job loss, health problems or the breakdown of cars and big-ticket household appliances.
No matter the emergency, it is highly unlikely to require coming up with six months of salary within 24 hours. That’s why some advisers suggest keeping emergency funds to a minimum except when you feel threatened, allowing you to grow savings in conservative, liquid bond investments that you could tap into if a catastrophe overwhelms your disaster cash.
• Life-insurance benefits should equal five times current income.
This rule — dismissed by some as an insurance industry marketing gimmick — also focuses on the wrong thing by looking at income rather than expenses. Like most financial rules of thumb, its suitability is a function of individual situations.
Experts say the five-times-income rule generally applies to the sole breadwinner in a family with two kids. That means it’s inadequate for larger families, and a waste for people yet to start a family.
With insurance, the idea should be for benefits to cover what you can’t otherwise afford to pay for. For most people, that means insurance must be sufficient to cover the mortgage balance, the kids’ college education, funeral costs and several years of expenses to allow loved ones to get back on their feet emotionally. It could be more or less than five times current income, and it will change over time.