Financial Planning Rules of Thumb: Better than ‘It Depends’

Financial Planning Rules of Thumb: Better than ‘It Depends’

Some financial advisors can be rather critical when it comes to financial planning rules of thumb, or heuristics that provide general guidance to households about how to invest, save or potentially spend in retirement. The most lamented is probably the 4% rule, but there are others such as target-date funds, delaying claiming Social Security, or saving 15% of your pay.

In each instance, the respective rule of thumb is obviously imperfect. Anyone who has put together more than one financial plan knows that people are different, with varying goals, preferences and situations. I vividly remember when I first started putting together financial plans, the target retirement income goal was different for every plan. I don’t know why this somewhat obvious fact struck me as it did, but it made me appreciate the fact that retirement looks different for every person.

Creating financial plans, especially good ones, takes time and expertise. Simply put, it isn’t easy. Financial planning can add a tremendous amount of value and is something I’ve discussed in research around the concept of “gamma,” which I wrote about a decade ago with Paul Kaplan when I was at Morningstar. Vanguard has their own relatively well-known version of this concept, which they call “advisor’s alpha.”

The crux of gamma, and really the value of advice in general, is the ability of a knowledgeable financial professional to create a better outcome for an investor than they would do on their own (e.g., following a naïve benchmark or just making it up). For example, in the original gamma research, we explored the benefit of a dynamic withdrawal, which involves regularly revisiting the withdrawal to ensure it’s prudent (e.g., given realized portfolio performance), versus a static strategy (in particular, the 4% rule). Not surprisingly, we found that updating portfolio withdrawals (or spending) over time can generate tremendous value (technically, more utility-adjusted income, but I digress). Static assumptions are still quite common in financial planning tools, though, which is something we need to actively address in our industry and I covered in this recent research.  

While making dynamic adjustments during retirement has the potential to improve retirement outcomes, that doesn’t mean following the 4% rule is necessarily bad advice, especially as a required savings target at retirement (i.e., you need approximately 25 times your portfolio income goal).  Sure, for some retirees, the safe initial withdrawal rate will be much lower (e.g., 3%) and for others much higher (e.g., 6%); however, determining the appropriate withdrawal requires engaging a financial professional and is within itself subjective, depending on the assumptions around spending, investment returns and longevity used in the financial plan.

Since it is unlikely every American is going to regularly engage a financial planning professional, rules of thumb can provide at least a useful starting place for optimal decisions. For example, while I don’t think saving 15% of pay, investing in a target-date fund and delaying claiming Social Security retirement benefits are by any means going to be the right strategies for everyone, if I’m not going to assemble a comprehensive financial plan, they aren’t a bad place to start.

As opposed to being openly dismissive of rules of thumb, I think financial advisors should embrace them for what they are: a five second answer to what is usually an incredibly complicated question. While simply responding “it depends” to these types of questions (an especially common response among academics … guilty as charged) would be another possibility, I think providing generic guidance steeped in research is far more actionable and materially better than insights that may be gleaned from a random Google search or TikTok video.

While caveating the complexity regarding many financial planning decisions is important, I would suggest my fellow financial planning professionals relax a bit regarding these rules of thumb. Rules of thumb aren’t competing with you for financial advice, rather they should be viewed as the starting place for a more meaningful conversation as the best-case scenario, and likely better than what someone without financial expertise would come up with their own as the worst-case scenario!



David Blanchett is Head of Retirement Research, PGIM DC Solutions