Friday, October 6, 2006

As a Rule of Thumb...

In an earlier post, I cautioned against putting too much weight into the usefulness of a rule of thumb. (See Wealth According to The Millionaire Next Door.) Let's build on my example, and take a single-income family (two people, no kids). Assume that one makes $80k/year, and they are both about 35 years-old. So according to the formula in The Millionaire Next Door, if they have over $560,000, they are PAWs (prodigious accumulators of wealth). For argument sake, suppose that they do have $560,000 in net worth, which would put them squarely in the PAW category.

Now, suppose the other partner decides to start a business, and their combined income increases by $60k to $140k. By the formula, they ought to now have $980,000 in net worth in order to stay in the PAW club. Well, they now fall $420k short of the mark. This sounds crazy, but the math proves it. Using this backwards logic, one could conclude that any activity that increases the income of the couple is a bad decision because it would change them from being PAWs (rich) to just plain average. Does this nonsense make sense to anybody?

Let's look at another example using two "rules of thumb." The first rule of thumb is that in order to have enough accumulated wealth to retire, one needs to be able to replace 80% of their current income in retirement through savings, IRAs, 401(k)s, and the like. The second rule of thumb is that one can expect to earn 4% on their accumulated savings in retirement (This is a conservative estimate that assures you won't run out of money after you quit working). Now suppose that an individual in his early 50s makes $100k per year. By the first formula, that person needs to be able to replace $80k per year in retirement. Using the second formula, the person has saved nearly $2,000,000. In the example, we assume a 4% interest rate: $2,000,000 X 4% = $80,000. So, he's all set!

Suppose, just months before early retirement, the boss comes by to acknowledge the great job he's been doing and offers a $10,000/year raise for his efforts. Let's run the numbers once again. A salary of $110,000/year X 80% = $88,000 that needs to be replaced in retirement. In order to guarantee this level of income, our friend needs to have saved $88,000 / 4% = $2,200,000. This is a full $200,000 MORE than he budgeted for.

That number, by the way, happens to be 20 times the amount of the raise. I can assure you that mathematically, a raise of any amount will require a 20X increase in savings based on these two "rules of thumb". So, the next time you are offered a raise, are you going to tell the boss, "No thanks, that will just push out my retirement date"? Of course not! Common sense alone tells you that you would be better off getting the raise, but a bunch of rules of thumb tell you that the raise will hurt you financially.

So, in summary, take a rule of thumb with a grain of salt.

Update: See also The Millionaire's Rule of Thumb.



foolarch said...

I will take a "pinch" of your advise.

mOOm said...

The millionaire next door rule of thumb is just nonsensical I agree. A model that makes sense should have the following two factors in it:

1. Be a function of consumption (expenditure) rather than income.

2. Be nonlinear to reflect the compounding effect of investment returns.

Maybe I should come up with simple one and put it on my blog :)

pfstock said...

I'm looking forward to your formula defining expected net worth as a function of age and expenditures. When you say nonlinear, I assume that you mean nonlinear with respect to age. This sounds like a novel piece of research; you might even be able to get a paper out of it.