Friday, December 29, 2006

Net Worth Benchmarking

The authors of "Millionaire Next Door" recommend that your net worth should be determined by the following formula:

Proper Net Worth = Age times Annual Income divided by 10.

I have a few problems with that formula. According to that formula, if I had the proper amount saved but got a promotion and a higher salary I would suddenly be deficient in my savings. A 20-year-old with an associate's degree and just starting his career needs to suddenly have 2 years income saved up. A 30-year-old medical doctor with a huge student loan debt is even further behind the curve.

Another issue I have with the formula is that a significant portion of most people's net worth is the equity in their home. To get at the equity in your home, you have to sell it. And not all of the supposed equity is yours, as there are real estate commissions and other costs with selling your home. And then you have to pay to live somewhere, unless you can find a nice comfy bridge that isn't already occupied to live under. On the other hand, there is some advantage to having the mortgage retired when you are as it reduces your expenses.

The net worth statements I see in the blogosphere also make no distinction between money in a tax-deferred retirement account and any other kind of balance, adding their 401k balance directly to the asset side of their balance sheet without any corresponding tax liability.

A better net worth benchmark would be based on the type of education you have and how many years since you completed it. More importantly, it would not be based on your income but rather your spending. Someone with $2M at retirement would usually be in good financial shape. But not if he had Bill Gates' lifestyle. I imagine the taxes and upkeep on his mansion would easily absorb that in a year.

I plan to report my net worth not in dollars but rather in months of average spending. That provides a better picture of whether my net worth is appropriate for me (not Bill Gates), and will provide a small amount of privacy should my identity be determined.

"Average spending" will be determined by over a fiscal year, subtracting from total income the amount of income taxes and other withholdings from my salary and the amount of any money I've set aside for retirement during the year, whether in a tax-advantaged retirement account or not. Average spending will then include actual expenditures as well as any money I save for nearer term goals, such as savings to pay taxes and insurance, replace my vehicle when it wears out, or for maintenance on my home.

I plan to report the following in units of months of average spending:

  • Emergency fund and long term savings held outside of retirement accounts
  • Tax-deferred savings, after subtracting the combined effect of my marginal federal and state income tax rates
  • Roth IRA balances, no adjustment for taxes needed.

What won't be reported:
  • Liabilities. My only liabilities are credit card charges from the current billing cycle, which I pay in full when billed. These liabilities are more than offset by assets which I don't report.
  • The value of my household items. Really, how much could I get for them if I held a garage sale or put them up on eBay? I may spend 99% more time figuring out my net worth than the average person does, but I've got better things to do than making an inventory of my silverware.
  • My house and vehicles. After all I'm using them and if I sold them I'd have to replace them as they wore out. Since I have no debts and therefore no payments, my spending is reduced, at least on the home which I expect to last my lifetime, so if I reported its value I'd also have to add imputed rent to my spending. If I did decide to report the value of my personal property, it would be a conservative value of my home and cars.
  • The value of my near-term savings, used for replacing and repairing my vehicles, repairing my home and replacing furnishings, paying property taxes and insurance, and money held just for handling monthly cash flow.
Instead of benchmarking based on my current age, instead I'll estimate my retirement income at three different ages (62, 66, and 70) based on current savings and current Social Security credits and subtract income taxes at today's rates, and report what percentage of my current spending would be replaced. Income from savings is determined by subtracting age at retirement from 100. I won't be adding inflation between now and when I actually achieve that age, but rather reporting in terms of today's spending. This assumes that my investments will keep up exactly with inflation.

There are some deficiencies in this method. For instance the cost of medical insurance. Or long term care. Although some of this is offset by the fact that I'm not considering the value of my home, which could be used to cover long term care costs. Also that my spending could change somewhat in retirement. But I have to start somewhere, and I think current spending is a reasonable approximation of retirement spending.