In the last blog article, I wrote about how some financial planning rules of thumb are helpful in certain situations, but can create unforeseen problems and don’t apply to other situations. Specifically, some rules of thumb related to savings rates can encourage workers to save for retirement, but might not apply for people who start saving later in life, or who are high earners. I also wrote about how some rules around how much house you can afford might jeopardize other financial goals without you realizing it. This week, I’ll discuss two more financial planning rules of thumb: how much life insurance you need, and how much you should put in stocks versus bonds within your investment portfolio.
Financial Planning Rule Of Thumb 3: Buy 10 times your salary in life insurance coverage
A common rule of thumb in the insurance industry is to purchase 10 times your annual salary. The specifics aren’t difficult to explain. Simply multiply your salary by 10, and there you have it. The rule of thumb is talking about the amount of death benefit, and doesn’t help you determine whether you need whole life or term insurance, or how long the term of the insurance policy should be.
Some people do, in fact, need 10 times their salary in life insurance. So if you happen to be one of those people, lucky you! You can use a super quick and easy rule of thumb, and you’ll happen to get exactly what you need. In all seriousness, though, this rule of thumb does have its advantages. For some people who don’t believe life insurance is important, it’s good that there’s a rule of thumb that encourages people to give life insurance some serious thought. I’ve known plenty of people who don’t think they need any life insurance at all, or only need enough to pay for their funeral.
Life insurance, in our view, is there to protect income and ensure that a family’s financial goals can be obtained even if someone in their family dies. Often times, those goals are unattainable with just a $100,000 policy, for example.
It ignores your retirement horizon
This old insurance rule of thumb is way too simple. An income multiplier ignores how long you plan to continue working. For example, if you’re 64 years old making $225,000 per year, and you plan to retire at age 65, do you really need $2,250,000 in life insurance? If you view insurance as a way to protect income, there was only one more year of salary to protect, so probably not.
It ignores your financial goals
Another reason an income multiplier is too simple is because it ignores your financial goals. Let’s say you’re 40 years old and make $150,000 per year. You’re married to someone who makes $280,000 per year, and you spend $120,000 annually, and you’re completely content with spending that amount. You aren’t saving anything for college for your two kids, because their grandparents are paying for their education. Do you need $1,500,000 in life insurance? Maybe not! With a spouse who earns $280,000 per year, he or she could probably support the type of lifestyle you want, and could save enough for retirement on that salary.
Now let’s compare that to another 40-year-old who also makes $150,000. Their spouse stays at home to watch the kids. They currently spend $90,000 per year, but want to be able to spend $120,000 per year when they retire. They’re also saving $5,000 per year for college for their two kids. For them, $1,500,000 might not be enough! If the goal is to provide college for the kids, and be able to spend more in retirement than they currently spend, they will need quite a bit of help from life insurance if the one working spouse dies.
Using a needs-based approach
Rather than using a rule of thumb to calculate how much life insurance you need, we use a needs-based approach. We start with your financial goals, consider how they might change if you pass away, and then calculate any gap that life insurance would need to fill. There are other ways you can calculate how much you need, but we believe a needs-based approach is typically best.
Financial planning rule of thumb 4: Subtract your age from 100, and that’s the percentage you should have in stocks compared to bonds.
Many investors who are saving for retirement – or who are already retired and are investing what they have already saved – wonder how much they should invest in stocks versus bonds. In other words, they’re wondering what an appropriate asset allocation would be for their age. It’s an important question that needs to be answered. The amount of money that is invested in stocks versus bonds affects your future returns significantly more than other portfolio characteristics. The individual stocks or bonds you might own, how much you have in different geographic areas, or whether you invest in large or small companies means little compared to how much you have in stocks versus bonds.
This rule of thumb provides a quick answer based on your age. If you’re 65 years old and you’re following the rule of thumb, you would have 35% of your retirement portfolio in stocks, and the other 65% would be in bonds.
Well, at least you’re not putting it all in gold.
It ignores your financial goals
Choosing an asset allocation solely based on your age is not a good idea. There is so much that goes into an appropriate asset allocation. Age is a big part of it, but how much you want to spend is also a big factor to consider. All things equal, the more you want to spend, the more return you might need, so the more you might need to invest in stocks versus bonds, which have higher expected returns in the long-run. They also have more risk, as is shown in the following chart.
It ignores your emotional response to risk
Different people respond differently to market volatility. During the market craziness that happened in February and March of 2020, some investors were invested in 100% stocks and didn’t flinch. Other investors had 50% stocks and 50% bonds, so their portfolios weren’t nearly as affected, but they sold everything because they couldn’t handle seeing their portfolios lose money. You need to choose an asset allocation that you can stick with during major market downturns. Selling after market downturns hurts you in the long run, because you might miss out on the recoveries that follow the downturns. The following chart shows how staying invested versus pulling out of the stock market would have affected portfolios over the past 25 years.
It ignores your resources
Your income stream in retirement is an important part of your stock/bond allocation decision. Most people will have social security in retirement. Yes, the government is spending tons of money and the pot of social security money is becoming smaller and smaller. However, the likelihood that the government completely abandons workers who earned a social security benefit is extremely low. You’re probably getting something. In addition to social security, you might have a pension from your former employer. If your pension plus your social security pays you $70,000 per year, and you only spend $65,000 per year, you might not ever need money from your retirement portfolio.
What does that mean from an asset allocation perspective? Some would say that if you don’t need the money, you might as well be super conservative with your money, because you don’t need a ton of growth that would come from stocks. Others would say you might as well invest in an aggressive allocation, because if you lose money, who care? You didn’t need it anyway. Ultimately, we believe it comes down to your risk tolerance and what you might want to do with leftover money once you die.
BOTTOM LINE – FINANCIAL PLANNING RULES OF THUMB USUALLY OVERSIMPLIFY COMPLEX ISSUES
To repeat the conclusion from the last blog post, financial planning rules of thumb have some value, but they’re unreliable when they’re used in a vacuum. If you are a complete DIYer, following rules of thumb is better than flying blind, and at least you’re seeking to take control of your finances. If you want to take it a step further and enlist the help of a fee-only financial planner, we’d be happy to talk with you to find out if we can help you with your financial life questions.