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Financial Rules of Thumb

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A rule of thumb, by definition, is a principle with broad application in its field that is not intended to be strictly accurate or reliable for every situation.

The exact origin of the term is uncertain, but one popular thought is that it came from carpenters using the tips of their thumb as a unit of measure. Each carpenter’s thumb differs to some extent, but for the purposes of rough measurement, it’s pretty convenient. However, if several decent carpenters are building a house, it will probably be standing at the end, but there are likely to be some crooked corners.

When it comes to personal finance, rules of thumb are frequently repeated and applied without much thought. Popular finance websites commonly feature simplified explanations of different concepts that seem easy to understand, but are often later misapplied. Different personal finance media personalities have been able to build their reputations by recycling some of the most common rules of thumb and package them up as prescient advice. A few we routinely hear from clients are:

“You’ll need 80% of your pre-retirement income to live on.”
“Buy a small home to start and upgrade along the way.”
“Subtract your age from 100 and invest that percentage in stocks.”

None of these are dangerous pieces of advice, but the problem with this approach is that it takes a unique situation (the client’s) and applies a shortcut to arrive at a general course of action. A bigger problem is that it can lead people to be over confident in their decisions without having a full understanding of the impact of their seemingly obvious decision. As advisors, we spend a lot of effort helping our clients to understand the problem they are facing in its entirety. I’m often caught in the office repeating that the answer to all financial planning questions is that, “it depends,” which is not an approach easily covered by one or two “rules of thumb.” Rather than an imprecise rule of thumb to guide our clients, we prefer to treat everyone like a fingerprint; each one is unique.

As advisors, we spend a lot of effort helping our clients to understand the problem they are facing in its entirety.

That said, there are some common goals that many clients share. For example, most clients do not want to outlive their resources. That doesn’t mean the same strategies will apply to every client with that goal. For instance, how we help clients to address the goal mentioned above is to help them maximize their savings through retirement withdrawal and social security strategies. Depending on the client’s circumstances, it can make sense to recognize some income in the form of distributions or conversions from their Traditional IRAs in order to take advantage of years when they are subject to a lower tax bracket. It can also make sense to recognize capital gains in lower income years to take advantage of the corresponding lower capital gains rate. Either of these recommendations may be the right one or could seem counter intuitive to some. Only if we take the time to walk the client through it with their particular situation in mind can we explain it in a way that they can have confidence in selecting the right plan for them.

Another example is opening 529 plans for education. Clients often ask us how they should go about opening a 529 plan or which 529 plan is best. Again, it depends. Clients will sometimes have a puzzled look on their faces when we ask them questions about their retirement savings plans in this context. It’s easy to see that they are thinking “What does this have to do with saving for college?” What very few clients realize is that some employer retirement plans, and even individual retirement accounts, allow for penalty free distributions to pay for education expenses, but 529 plans don’t allow for penalty free distributions for retirement. All things being equal, they shouldn’t tie unnecessary strings to their savings. It’s usually only after fully contributing to these other accounts that it makes sense to open a 529 plan. There are other reasons that clients might want to fund a 529, but those usually have to do with earmarking those dollars for education. However, there is also a whole different set of issues with grandparents saving in 529s for their grandchildren that effect financial aid eligibility. Once more we see that a single rule of thumb will not work for everyone.

Some of the best financial experts take these “rules of thumb” and turn them on their heads to show clients how the opposite approach may in fact be the right one. By doing that the client can see that there are numerous ways to think through unique personal finance issues and that generic blanket recommendations can easily result in less than ideal outcomes.

We’ve had countless interactions with clients where their response is “I wasn’t aware of that!”

Clients often don’t have the time or desire to fully understand the complexities of their financial situation and how to maximize their wealth in concert with their goals. That’s where working with a team of advisors can provide a substantial benefit. Our advisors do the work to make sure that they fully understand our clients’ hopes, fears and dreams. They combine that with all of the different financial concepts and options that could apply to our clients’ individual situation then make thoughtful recommendations. We’ve had countless interactions with clients where their response is “I wasn’t aware of that!” Sometimes we are able to help our clients by applying the strategies referenced above, but other times we are able to help by giving clients a different way of thinking through a decision they are facing.

The biggest value that an advisor can provide to a client is to align their capital with their values, beliefs and goals. It takes time, trust and discussions to understand what truly matters to each client we work with. Only after we truly understand those things are we able to give thoughtful and prudent advice, not just financial rules of thumb.

About the Author

Brian Bruggeman Headshot

Brian K Bruggeman, CFP®, CTFA

Executive Vice President
Chief Innovation Officer
Director of Financial Planning