Financial rules of thumb can be cliche, but personally, I love the simplicity of a formula that spells out in one sentence if my budget and financial goals are on track. And sometimes, if a pragmatism is overused, it's because it's tried and true. It really works!
There is no replacement for a full blown financial plan customized to your goals and objectives. But that takes time, and it's hard if you haven't really ever thought about your money. You wouldn't make any life-altering decisions based on a generic rule, but following a simple and proven philosophy is a great way to start thinking about your money. A rule of thumb that clicks with you may even motivate you into taking corrective action, or reassure you that things aren't as bad as you fear. So here are three mantras that may be a fit for your finances:
1. Save this much for retirement by this age
Ever wonder if you are on track with your retirement saving? Stop wondering and find out.
Most financial firms have a chart showing how much to save and by when with specific checkpoints, like this one from JP Morgan Asset Management. The matrix is easy to read and takes into consideration income, reasonable growth rates, and a long retirement (30 years). Using this schedule, a 40-year-old earning $100,000 should have 2.9 times their income or $290,000 in retirement savings. This assumes they continue to contribute 10% to their retirement accounts.
Fidelity has an even easier rule of thumb: Aim to save at least one year's salary by age 30, three times your salary by age 40, six times by age 50, eight times by age 60, and 10 times by age 67. The outcome may be similar to JP Morgan's. For example, with Fidelity's rule the 40-year-old earning $100,000 needs three years' salary or $300,000 -- close to JP Morgan's estimate.
If this is all sobering news, it goes to show you how much you must save for retirement. But familiarizing yourself with these ballpark figures can empower you to take the necessary steps to get on track.
If you need to catch up on retirement savings, start by increasing the percentage of your paychecks you contribute to a 401(k), if you have one. If you're already maxing out your 401(k) or you don't have access to a workplace plan, consider setting up an automatic monthly deposit into an IRA or Roth IRA. You may also want to review your daily expenses to find places you can reduce or eliminate spending, and then use that money for retirement savings. Any way you slice it, there's no better time to get started than the present. Now that's a great rule of thumb.
2. Save this amount for college by this age
Here's another doozy: college. Remember the good old days when you could work part-time and pay for college along the way? It seems like a lifetime ago; College tuition has skyrocketed over the years.
If you have more than one child, then surrender yourself to reality -- college is expensive, will only become more expensive in the future. Sending your kids to college will require some sacrifice on your part, but all things are possible if you set a clear goal and have a realistic plan for saving and investing for future college costs. But you need a starting point to work from.
Fidelity has a neat rule called the "college savings 2K rule of thumb." Simply multiply your child's age by $2,000, and this is the amount you should have saved for that child's college education. There are two caveats to this rule: first, it assumes your child attends a four-year public college, not a private school. The second thing to know is that the rule assumes you only save up to 50% of the total cost of college; Fidelity reasons it's too hard to save 100%, and parents can use their income or take out low-interest federal student loans to pay the difference.
It's not a perfect rule, but it does get us thinking. When saving for a seven-year-old to attend college, you should have $2,000 times 7, or $14,000, if the goal is to have half saved for a public college by the time they're ready to go. This also assumes you keep saving at your current savings rate, so don't stop once you begin. Make it a habit and pay your child's college savings first, before spending on extras each month.
There are many ways to save for future college expenses, a 529 college savings plan or a custodial account, but the main point is to start saving now!
3. Buy this amount of life insurance
No financial plan is complete unless you've considered how an early or untimely death would decimate your family's financial situation. To determine how much life insurance you need, a common rule of thumb is to buy a policy 10 times your salary, so someone earning $100,000 should have $1 million in life insurance.
This is widely considered too simplistic by many in the insurance industry and it's a start, but a more thoughtful approach is to figure out how much your loved one needs in income and multiply that by 25. This rule of thumb is built on the 4% rule, which means a life insurance death benefit should provide a lifetime income of 4%, multiplied by the death benefit. A $1 million life insurance death benefit should provide $40,000 of income (4% of $1 million) for the life of the survivor. This is the same as saying 25 times the needed annual income of $40,000, which also equals $1 million. The 10-times-salary method gives you only $400,000, which leaves the survivor rather short.
You may want to add costs for college and paying off a mortgage on top of that. Also, having life insurance for both spouses is usually a good idea, to provide flexibility if something happens, such as by enabling one spouse to take time off from work to be with the kids in the wake of a tragedy.
There are various types of life insurance, but term life insurance is a cheap and simple instrument to meet your need. You may even have access to group life insurance at work. Finally, keep in mind that a rule of thumb is a starting point and shouldn't replace a more thorough analysis that accounts for Social Security earnings and earnings of the surviving spouse if he or she continues to work, both of which could change the life insurance calculation.
Rules of thumb are a great way to get you thinking about your financial planning. Though they are not perfect, but these three get you in the ballpark of where you need to be and should motivate you to take a deeper dive into your own finances or explore a more customized analysis when you have the time.