You must have come across various personal finance thumb rules. They may be about the budgeting system to follow, emergency fund amount, life insurance cover amount, equity allocation, retirement corpus, etc. Thumb rules are a good starting point, but they are generic in nature.
On the other hand, everybody’s situation is different and may need a customised solution. We will discuss some personal finance thumb rules and how to customise them as per your requirement.
50/30/20 budgeting
Before you start investing towards your financial goals, you must allocate your income between expenses and savings and investments. A budgeting system like the 50/30/20 system can help you do that. As per this system, you must allocate your income as follows: 50% for needs, 30% for wants, and the remaining 20% for savings and investments.
Are you one of those individuals who scratch their head before the end of the month, wondering where you spent all your income? If you are not following any budgeting system, the 50/30/20 budgeting system is a good one to start with. With a 20% allocation, it will get you started with saving and investments.
Gradually, you should increase your allocation towards savings and investments beyond 20%. Eventually, you should aim to migrate to the “Pay Yourself First” budgeting system. In this system, you first allocate income towards your savings and investments for all financial goals. After that, whatever income is left is allocated towards expenses for needs and wants.
The "Pay Yourself First" budgeting system is ideal as it helps you prioritise and reach your financial goals faster.
Emergency fund equivalent to 3 months’ expenses
If you don’t have an emergency fund, you should start building one immediately. An emergency fund with 3 months’ expenses is a good starting point. However, this may be suitable for people with a Government job or a steady job in a private company doing well financially in a rising industry.
People working in companies/sectors not doing well financially may need a bigger emergency fund with around 6 months of expenses or even higher. For self-employed or business persons, the monthly income and cash flows are uneven and not predictable. These people may also need a bigger emergency fund with 6-9 months’ expenses.
The thumb rule talks about having an emergency fund with 3 months’ expenses. But you should assess your situation and accordingly build and maintain an emergency fund with the required amount.
Life insurance cover equivalent to 10 times annual income
Are you someone who doesn’t have any life insurance cover, or are you taking comfort from the life insurance cover provided by your employer? If yes, the thumb rule of having a life insurance cover equivalent to 10 times your annual income is a good starting point.
However, beyond that, you should assess your needs and accordingly arrive at the appropriate life insurance cover. You can use various methods to determine the life insurance cover you should have.
For example, as per the Human Life Value (HLV) method, the present value of the total income you will earn during your working years should be your life insurance cover. Another method considers the expenses, such as family's monthly expenses, loan EMIs, child's education and marriage, spouse's retirement expenses, etc., for arriving at the life insurance cover amount.
The life insurance cover amount should be based on your needs and not on the thumb rule that is generic in nature.
Equity allocation = 100 – age
As per this thumb rule, your equity allocation should be 100 minus your age. For example, if you are 30 years old, the equity allocation should be 70% (100 - 30). Well, this is not the most appropriate way to decide your equity allocation.
A 30-year individual with a conservative risk profile will not allocate 70% to equity based on the thumb rule. Similarly, equity allocation is not recommended for a short-term financial goal that has to be achieved within 3 years. The thumb rule requires an individual to have 40% allocation to equities at the retirement age of 60 years. Not many investors will be comfortable with that.
Your equity allocation should be based on factors such as your risk profile, asset allocation, time left to achieve the financial goal(s), and of course, your age.
Retirement corpus equivalent to 20 times annual income
As per the above thumb rule, your retirement corpus should be 20 times your annual income. For example, if your annual income is Rs. 10 lakhs, your retirement corpus should be Rs. 2 crores as per the thumb rule. You shouldn't calculate the retirement corpus in this manner.
To calculate your retirement corpus, take the following steps:
- Calculate your expenses in the first year of retirement based on the expected inflation rate, monthly expenses, and the number of years left for retirement.
- Based on the expenses in the 1st year of retirement, your expected life span during retirement years, inflation rate, expected rate of return on the retirement corpus, calculate the retirement corpus.
The retirement corpus should be such that you can make an annual withdrawal based on your annual expenses during the retirement years. The annual withdrawal amount will increase every year with the increase in annual expenses based on inflation. The remaining retirement corpus amount will be invested and earn an expected rate of return. Over the years, the retirement corpus will be reduced by the annual withdrawal amount and get exhausted at a certain age. For example, many people consider life expectancy as 80 years and calculate their retirement fund based on this age.
Thumb rules should be customised as per one’s needs
Apart from the above five thumb rules discussed in this article, there are many other thumb rules. There is nothing with these thumb rules; you should use them for guidance. However, the thumb rules are generic in nature, and everyone's circumstances are different. Hence, you should customise the thumb rules based on your circumstances to suit your requirements for the best results.
Gopal Gidwani is a freelance personal finance content writer with 15+ years of experience. He can be reached at LinkedIn.
