With the end of the year quickly approaching, how do things look? Specifically, are you on track to meet your goals? Have you measured? What gets measured is more likely to be accomplished. Computing your net worth once a year is the first and most important step toward financial security.
Net worth is a snapshot of how much money would be left if everything you owned were converted into cash and all your debts were paid off. Your net worth is computed by creating four smaller lists.
Liquid assets: An asset is something that you own that is worth significant value. A liquid asset is something that can be sold in a matter of days. Include all of the following types of investments: personal bank accounts (checking, savings, money market), certificates of deposit, bonds, mutual funds, stocks, and exchange traded funds. Use values on a specific date so that all of your amounts will be on the same day.
Non-liquid assets: Non-liquid assets are those things that you own that cannot be quickly and easily sold without penalty. In this category include the value of your retirement accounts (IRAs, 401ks, 403bs, Keoghs, Profit Sharing Plans, and Pension Plans). Also include any real estate investments including the market value of your home. Using the assessed value is an easy indicator of the market value of your home.
Other non-liquid assets can include business interests such as proprietorships, partnerships, or company stock in a company that is not publicly traded. Include the cash value of any life insurance that is not term insurance. Some people include personal property such as jewelry, collectibles, cars, and boats in this category. While these often have a high retail value, their true worth is often a small fraction of their initial cost. I recommend not including personal property.
Immediate Liabilities: Now list what you owe to creditors. These are called liabilities and are also divided into immediate liabilities and long-term debt. Immediate liabilities include credit card debt, car loans, student loans, and any other loan, bill or debt that must be paid within two years.
Long Term Debt: The last category lists long-term debts. For most people this is primarily their home mortgage, but may include other real estate or business loans.
The first time you gather all of this information will be the most challenging, but in subsequent years it becomes much easier. By keeping a record of your net worth each year, you have a valuable tool for financial planning.
Now compute three additional values: Your Total Assets by adding your Liquid Assets and Non-Liquid Assets. Your Total Liabilities by adding your Immediate Liabilities and Long Term Debt. And finally, determine your Net Worth by simply subtracting your Total Liabilities from your Total Assets.
Now that you have computed your Net Worth, you can use these numbers to compute other values useful for reaching your financial goals.
Your Emergency Reserve (Liquid Assets minus Immediate Liabilities) should be at least half of your annual income. Any amount more than this can be invested more aggressively for appreciation. Your Debt Load ratio (Total Liabilities divided by Total Assets) should be under 35%, with your home mortgage comprising the majority of your debt. If you are aggressively trying to pay off your mortgage instead of aggressively trying to save and invest, your efforts are laudable, but mistaken. The quickest path to wealth includes having a home mortgage that could be paid off, but choosing not to in order to take advantage of the tax benefits. The rich wisely leverage and invest.
The most important use of a net worth statement is to measure your progress toward retirement. In order to retire at age 72 and have sufficient funds to maintain your standard of living you need about twenty times your annual spending.
Take your net worth and divide by your annual take home pay. This is how many times your annual standard of living you have amassed in savings. If you are under 40, the number is probably less than five. That’s ok; it is supposed to be.
Progress toward retirement is not a linear function. To those of you wondering if the math you studied in high school is useful, the following equation was determined by quadratic regression. It estimates how much of your current net worth you should have saved given your age. This gives you a benchmark for determining if you are on track to retire by age 72.
Take your age and divide by 166. Then subtract fifteen hundredths (0.15). Finally, multiply the result by your age. The resulting number should be between zero and twenty. That number is how many times your current annual income you should be worth.
Pull out your calculator and follow an example. If you are 45 years old then forty-five divided by 166 equals 0.2711. Subtract 0.15 to get 0.1211. Then multiply by 45 again. The result is 5.45. By age forty-five you should be worth about five and a half times your annual spending. More sophisticated retirement planning includes the difference between taxable, tax deferred and Roth accounts as well as Social Security guesses and defined benefit plans, but this is a good approximation of your progress. Here is a table that shows by what age you should have saved different multiples of your annual spending.
|Age||Annual Spending Saved||Age||Annual Spending Saved|
If your net worth is a higher: Congratulations! You are on the path to retiring earlier than 72! For every 0.5 you are over, you could consider retiring about a year earlier. Conversely, for every 0.5 you are under your age’s benchmark you may have to work an additional year beyond 72.
Between the ages of 40 and 60 your net worth should increase by one unit of your annual spending every two years. That means that your current net worth divided by your take home pay should be one unit greater than it was two years ago. Alternately, if you are between 40 and 60, your net worth should have increased this year by half of your take home pay.
This is because money makes money, and by the time you are in your 40’s you should have enough investments to be earning about half of your annual spending each year. The compounded growth of your investments does the lion’s share of the work while you only need to contribute 15% of your current earnings. If you save 15% of your take home pay between age 20 and age 72 you should have sufficient savings in retirement. This is despite the fact that you will have saved less than 7 years worth of pay and many of those years will have been at a lower rate of pay. How much you save and invest is the primary determination of your financial future.
Want to retire younger? Try lowering your standard of living. In retirement, most people spend about 70% of the gross salary they earned while they were working. If you can live off 50% of your take home pay, you don’t need as much savings to maintain that lower lifestyle.
Need to catch up? Save more than the 15% of your take home pay. Determine how far you are behind and what additional percentage you can save each year. For example, at age 30 you should be worth 1.4 times your annual income. What should you do if you are only worth 1.1 times your annual income? Normally, to stay on track you need to save 15% of your income each year. In order to catch up you need an additional 0.3 times your annual income. One option would be to save an additional 10% of your income for three years. If saving 25% of your income is too much, try saving 20% (an additional 5%) for six years.
David John Marotta works at Marotta Asset Management, Inc. of Charlottesville which provides fee-only financial planning and asset management.
Image courtesy of josef.stuefer