By FPA member Scott M. Kahan, CFP®

Last Updated: March 28, 2011

Let’s see, you’re 40 years old. You feel you’re following all the rules of thumb to ensure your current and future financial security: saving 10 percent of your salary, putting aside three months of expenses for emergencies, purchasing five times your salary in life insurance, investing 60 percent of your portfolio in equities with no more than 10 percent in your company stock.

But are you really financially secure? More often than not, rules of thumb are just that, rules. What are not taken into account with rules of thumb are the variables that can affect each individual’s situation. Rather than using the rules as “rules,” it’s important to look at them more as guidelines that you use as a starting point to a comprehensive financial plan.

Here are some of the more popular rules of thumb and considerations that can greatly affect how closely you can follow the “rule.”

Emergency Funds

Rule of thumb: Traditionally, it’s been recommended to have three to six months of expenses set aside as an emergency fund. More recently, it’s been recommended to have the same amount of months set aside as what the unemployment rate is — currently that would mean about nine months.

The variables: Depending upon your job stability and the field you’re in, this guideline could vary greatly from person-to-person. Individuals in stable fields (e.g. medical, education) may need less in their emergency funds than those in more volatile fields (i.e. financial, manufacturing). The amount of debt you have can also affect the amount of money you need.

For retirees, your emergency fund could provide the monthly withdrawals you make from your portfolio to cover your expenses, so in this case you may actually consider keeping 12 months of withdrawals available. Handling your emergency fund this way in retirement would then allow you to ride out a storm and not be forced to sell into a down market cycle. 

Finally, if you are short of the needed amount, don’t sacrifice other savings to build it up. Continue adding to 401(k)s, etc., and allocate some monthly surplus to the emergency fund.

Your guideline: A good place to start finding where you need to be with your emergency fund is to add up your fixed expenses that are essentials (mortgage, rent, car payments, food, insurance, etc.). Then try to put as many dollar figures next to each of your own variables. That way you can add this up along with your fixed expenses to come to a closer figure that’s going to be right for your emergency fund needs.

Investments

Rule of thumb: Equities return 10 percent over the long-haul and 100 minus your age should equal your equity allocation. But as we have seen in the past 10 years, getting a 10 percent return on equities was hard to come by.

The variables: Economic conditions are going to be one of the biggest factors in the long-haul return on investments. If we’ve learned nothing else from the past 10 years of market cycles, getting a constant 10 percent return on equities can be hard to come by.

The second biggest variable in this area would be your individual risk tolerance. Your level of risk tolerance affects the balance of your equity allocation in your portfolio and then in turn can affect how easily the portfolio can ride out the ups and downs of the market cycles. To calculate your risk tolerance, you need to look at both your financial and emotional tolerance. For instance, how did you hold up in the recent market sell off? Did you panic and sell everything or did you see this as an opportunity to buy? There are many questionnaires available that will help you determine your risk tolerance. From there, you can start to determine an appropriate allocation that is right for you.

Your guideline: This is one area too important to leave to rule of thumb. Consulting with an investment professional and determining your risk tolerance is your best guideline.

Retirement

Rule of thumb: You should have 20 times your salary saved for retirement and plan to replace 80 percent of pre-retirement income.

The variables: Retirement is much like your working years in the sense that there are different phases. In the early retirement years, people often spend more than anticipated. Traveling to places you never dreamed of and visiting the grandchildren can cost more than anticipated. As you get older, people often start to travel less, but may spend more time and money giving gifts to grandchildren or helping with college payments. Finally, in the later years, medical costs can eat up much of your budget.

The guideline: Start sooner rather than later talking about your vision for retirement and the type of lifestyle you want. Continually revisit this vision, so that as you get closer to retirement, you can feel more confident that you’ve determined the costs and plan accordingly. It’s always important to know, though, that things can change and you should be ready to consider how this may affect your retirement years. Do the number crunching, assume realistic rates of return and don’t forget about inflation.

Life Insurance

Rule of thumb: You should have five to 10 times your income in life insurance.

The variables: Although, this is a good starting point, you’ll want to take into account factors such as whether you’re the primary earner or not, your health, your family’s health history and the sort of debt your household may be carrying or knows it will carry. For instance, a stay-at-home parent that has no income still needs coverage because in the absence of that parent, a full-time nanny would possibly have to be hired to continue to allow the primary earner to continue to work. You’d want to not only consider what it would take to cover your mortgage, but you may have future or current education costs that would also need to be covered.

The guideline: Basically, you need to consider, if you were to die, who would suffer from the loss of your income? Can a spouse or partner earn more to cover some of the lost income? The calculation can be complicated. But once you have considered your personal situation, factored in a rate of return on household investments and inflation, there is a good chance the final figure will wind up being what the rule of thumb recommends. At least you can rest assured knowing it is based on some reasonable calculations.

When it comes to your present and future financial situation, it’s important to know that the “rules” should never replace comprehensive financial planning and seeking out the advice of a professional to guide you may be the best “rule” you could follow.

FPA member Scott M. Kahan, CFP®, has devoted his career to helping individuals, families and small business owners reach their financial goals. Kahan is president and founder of Financial Asset Management Corp. a fee-only wealth management and financial planning firm located in New York City.