Since the end of last year, the U.S. markets went up and then down and then back up to end the year sideways. Market volatility was especially pronounced in the European Union as sovereign debt and the struggle to enact austerity measures whipsawed the markets, although not as a result of any changes in the underlying fundamentals.
If you are within 20 years of retirement (age 45 to 65), it’s critical to get your retirement planning updated. Computing your net worth annually is like taking a sextant reading to chart your course toward financial security. The changes of the past year provide another incentive to take stock of where you are in relation to your goals and readjust your asset allocation and savings rate.
Net worth gives you a snapshot of how much money would be left if you converted everything you owned into cash and paid off all your debts. Compute your net worth by creating four lists.
Liquid assets: An asset is something you own that has significant value. A liquid asset can be sold in a matter of days. Include personal bank accounts (checking, savings and money market), certificates of deposit, bonds, mutual funds, stocks and exchange-traded funds. Use values as of December 31 of the previous year so all of your amounts are calculated on the same day.
Nonliquid assets: Nonliquid assets are those things you own that incur a penalty when they are sold. Include the value of your retirement accounts (IRAs, 401(k)s, 403(b)s, SEPs, profit-sharing plans and pension plans). Add real estate investments as well as the market value of your home. Use the assessed value.
Other nonliquid assets may include proprietorships, partnerships or company stock in a firm that is not publicly traded. Add the cash value of any life (nonterm) insurance. Some people include jewelry, collectibles, cars and boats in this category. Although these items often have a high retail value, their true worth is often a small fraction of their initial cost. I do not recommend including personal property.
Immediate liabilities: List what you owe to creditors. Immediate liabilities include credit card debt, car loans, student loans, other loans and any bill or debt that must be paid within two years.
Long-term debt: For most people, long-term debt is primarily their home mortgage, but it may encompass other real estate or business loans.
The first time you gather all of this information will be challenging, but it gets much easier each subsequent year. By keeping an annual record of your net worth, you’re creating a valuable financial planning tool.
Next compute three additional values. For your total assets, add your liquid and nonliquid categories; for your total liabilities, add your immediate liabilities and long-term debt; and finally, for your net worth, simply subtract your total liabilities from your total assets.
Use these net worth numbers to compute other values useful for reaching your financial goals. For example, your emergency reserve (liquid assets minus immediate liabilities) should be at least half your annual income. Any extra 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 most of your debt.
If you are trying hard to pay off your mortgage ahead of schedule instead of making a huge effort to save and invest, your attempts are laudable but mistaken. The quickest path to wealth includes holding a home mortgage you could pay off but you choose not to in order to take advantage of the tax benefits. The rich leverage wisely and invest.
A net worth statement helps you measure your progress toward retirement. At age 65 you can only withdraw 4.36% of your portfolio to maintain your lifestyle. In other words, to keep the same standard of living, you will need about 23 times what you spend annually.
Take your net worth and divide it by your annual take-home pay. The result shows you how many times your annual standard of living you have amassed in savings. If you are younger than 40, the number probably comes to less than five, which is adequate for now.
By age 45, you should be worth about seven 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 the method described here will approximate your progress. This table shows by what age you should have saved different multiples of your annual spending.
|Annual Spending Saved
|Annual Spending Saved
If your net worth is higher, congratulations! You may be able to retire earlier than 65. For every 1 unit you are over, you could consider retiring about a year earlier. Conversely, for every 1 unit you are under your age’s benchmark, you may have to work an additional year beyond 65.
Between ages 40 and 50, your net worth should increase by 1 unit of your annual spending every two years. That means your current net worth divided by your take-home pay should be 1 unit greater than it was two years ago. And if you are between age 50 and 65, your net worth should have increased this year by 1 times your take-home pay.
Want to retire younger? Try lowering your standard of living. Most retirees spend about 70% of the gross salary they earned while working. If you can live off 50% of your take-home pay, it’s not as essential to save as much.
Need to catch up? Save more than 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 1.5 times your annual income. If your numbers don’t match that ideal, an additional 0.3 times your annual income will help you get there. You could save an additional 10% of your income (for a total of 25%) for three years. If that’s too much, try saving 20% (an additional 5%) for six years.
Money makes money. By the time you reach your 40s, you should have enough investments to be earning about half of your annual spending each year. Early in life what you save is most important for building wealth, but as you approach age 40 what you earn on your investments becomes critical. While you are young, the best advice a professional can offer is to “save.” As you amass significant wealth, it is more pressing to “manage” well what you already have.
All financial planning begins with a clear understanding of your net worth. A PDF template on our website (www.emarotta.com/networth) can help you compute and keep track of your net worth each year. Contact us or visit our website to download a free copy.
Photo by Megan Marotta