My Net Worth Says "Ouch"!

Here's a chart of my latest net worth estimate. Ouch!! My 401(k) (pink area at the top) took a hit from the recent stock market decline.

For now though, I'm remaining in the stock market, my 401(k) plan offers some good index funds.

I haven't made any adjustment to my property value (area in green) yet. I have been basing the value of my house on the tax appraisal that comes out one a year. Given the housing market slowdown due to the credit crunch, I'd expect that to happen. But the cynic in me suspects that they'll never reduce the tax appraisal.

Tracking my Net Worth

Many bloggers publish their net worth figures. I will not be providing figures, but do show the graphic to the side to illustrate my method. The graph tracks my net worth over the last several years and separates it in to categories.

Starting from the bottom of the graph:
-- The blue area is cash and demand deposits.
-- The area above that is government savings bonds, which are almost as liquid as cash.
-- The yellow area represents the value of stocks held outside of retirement accounts.
-- The green area is the value of my titled property (house and vehicles) less any loans (none).
-- The dark red area is the value of my Roth IRAs.
-- The pink area at the top is the value of my tax-deferred retirement accounts, traditional IRAs, 401(k)s, and the cash value of my company pension.

By doing this, I can see liquid assets on the bottom, retirement assets on the top, and property assets in the middle. Or you could view it as short term on the bottom, long term at the top. There is some debate in the personal finance blogosphere as to whether or not the value of your house is really part of your net worth. I think that it is, but its liquidity is low. And if you do sell where are you going to live -- in a tent at a rest area or under a bridge? I think you should have an awareness of the portion of your net worth tied up in your property, but keep it in perspective.

Were I to report figures, they would be lower than what most people would report. Most people would simply add up the market value of their stocks, their 401(k) balances, market value of their house, etc. However, I discount account balances to be more realistic:
-- My government savings bonds are discounted by the taxes on accrued interest, at my current marginal rate.
-- Stock values are discounted by capital gains taxes.
-- My car values are the blue book wholesale value. The value of my house is estimated at 75% of the tax appraisal, to account for real estate commissions, fix up costs, etc, and any error in the tax appraisal (though it is usually about right).
-- My tax deferred savings is discounted as though I had to pay taxes at my current marginal rate. My actual tax rate in retirement may be lower, or contrary to most popular opinion may be higher. But it makes this year's decision as to whether to fund a Roth IRA or tax-deferred savings neutral with respect to tracking net worth.

My method isn't perfect. If it were, I would include the value of my household goods. But why bother? How much would I really get for them at a garage sale?

But in the end, it's like any good net worth tracking scheme. It allows me to get a sense of my progress.

Net Worth and Retirement Saving Status, 2006 Year End

As discussed in this post, I'm reporting my net worth in terms of months of spending. So here goes:

• Non retirement account savings --> 20.46 months
• Tax-deferred retirement savings -> 79.37 months
• Roth IRA retirement savings------> 11.30 months
• Total --------------------------> 111.13 months

Based on current savings and Social Security credits and subtracting estimated taxes, I estimate my income in retirement based on retiring at the following ages, and stated in terms of replacement of current spending:

• Age - Current Spending replaced
  
• 62 ---- 73.44%
  
• 66 ---- 90.63%
• 70 --- 112.64%

Again, this is based on savings to date. With future savings, I'd like to get the replacement rate well above 100% before I retire, to provide margin for changes in spending for things such as health care and lifestyle changes -- I might want to travel more. I have a few more years to improve these numbers. By the time I reach the age of 62, I expect to be able to have the spending replacement for that age over 100%, provided I can maintain my current savings rates and the stock market doesn't crash.

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.