Benchmarking Your Financial Position
Benchmarking Your Financial Position: Measuring Your Progress Over Time
As a financial planner the number one question I get from people is 'how am I progressing financially - will I be able to retire in comfort?' While there is a reasonable amount of information around about how much a person might need for a self funded retirement, usually somewhere around 17 to 20 times their hoped for retirement income, I am not aware of any models that try to measure the way this wealth is built over time.
Thomas Stanley and William Danko, in their excellent book 'The Millionaire Next Door', (Longstreet Press, 1996), propose a formula for a persons net wealth based on a their age and income. They suggest that a person's net wealth should be:
By this formula, a 30 year old person with an income of $30,000, would have a target wealth of (30 × $30,000) / 10 which equals $90,000.
This is a useful start, but I decided that a model more suited to the Australian context, and the realities of life, and could be developed. Importantly, I think that the formula proposed by Stanley and Danko is unrealistic for people just starting work, and for those at the point of retirement.
For example, someone who attended university following school, is 22 years old and earning $40,000 is unlikely to have the target net wealth calculated under the Stanley and Danko formula which would be $88,000. At the pre retirement stage someone who is 60 years old and earning $100,000 would be calculated as having a net wealth of around $600,000. If they were planning on retiring, they might be disappointed to see that this level of assets might only generate a retirement income of $30,000 to $35,000 annually, based on the $600,000 providing an income stream of 5% to 6%. So I suggest that we construct a more flexible wealth benchmark model to measure personal financial progress.
To do a benchmark model I propose two basic assumptions:
To work out our final wealth requirement, we can calculate that around 18 times our required retirement income will provide this income. So, if we decide that we require an income of around $50,000 in retirement, a final net wealth of around $900,000 would be sufficient to provide this outcome. To provide an income of $50,000 annually the $900,000 needs to provide an income return of 5.55%. Currently Australian shares are paying gross income (including the value of franking credits) of around 5.7%, listed property rusts 7.5%, fixed interest investments 6-8% and cash around 4.5-5.5%. So we can see that a balanced portfolio of $900,000 should comfortably provide this level of income, providing we are not losing too much of this income in fees to financial planners, fund managers and the like. Investments life Australian shares and listed property trusts have growing income streams, so this income should grow over time.
Having said that we need around 18 times our retirement income, let us assume that the intended retirement age is 60. This effectively allows people to retire 5 years before the age pension age of 65.
We need to pick a starting point for our model, and I suggest that age 25 is a reasonable starting point. I assume that prior to this people are traveling, studying and spending most of the money that they earn. Of course, this is a gross generalization. However these generalizations are required to build a generic model. So, at age 25 we will assume that people have a starting wealth of 0 times their required retirement income.
It seems to be wise to pick 5 years as a timeframe for checkpoints. This gives people 8 checkpoints from age 25 to retirement, to measure progress. In each 5 year period net wealth can be increased by two things, wealth saved and investment returns. Wealth saved will simply be the sum of all the money saved and then invested over a period. Investment returns will be the returns earned on the wealth invested in any period. It is reasonable to assume that in any 5 year period your investments receive a total return after inflation of 25%, or 4.55% a year. Two really important comments need to be made here. Firstly, 5 year returns are likely to vary widely, so you will need to expect higher returns in some periods and lower and even negative investment returns in other periods. Secondly, the 25% total return in any period after inflation is only a very rough estimate of returns, so you should be cautious in using this as a prediction of expected returns.
I exclude a person's principal place of residence as an asset, but include their superannuation. Owning a home does have a benefit in that it will lower your required income in retirement, as you will not have to pay any rent.
I have assumed that between the ages of 25 and 45 the person or couple has the capacity to save 1 times their required retirement income each 5 years. Remember, this saving includes the contributions made to superannuation over this period. For example, let us consider a couple who are both earning $40,000 and require a total retirement income of $50,000 in today's dollars. The model suggests that in any 5 year period between ages 25 and 40 that they would have to save around $50,000, which is 1 times their required retirement income. Each of them would be building their superannuation balance each year through compulsory employer contributions equal to 9% of their salary, less the 15% contributions tax that they would be charged on these contributions. Together, this equals $6,120 a year, or $30,600 over the 5 year period. So, they only need to save another $4,000 a year, or $80 a week, to reach the required saving of $50,000 in this period.
Between the ages of 45 and 60 I have assumed that the person or couple is able to save 2 times their required retirement income in each 5 year period. I have assumed this higher saving rate based on the assumption that their house mortgage may be paid off, they are at a point in their life when their income level is likely to be highest and children may be becoming less of a cost.
Table of Wealth Benchmarks Over Time
All figures are expressed as a multiple of final required retirement income
Ending wealth: expressed as a multiple of desired income expressed in today's dollars.
Note: In each five year period the 'desired income in today's dollars' will have to be reassessed.
An Example of the Benchmarks in Action
Let us assume that I am a 25 year old with a net wealth of -$10,000 (credit card debt). I am working and earning $35,000 a year. At this stage I would like to retire at around age 60 on an income of $30,000 in today's dollars.
To be on track at age 30 I should have net wealth of 1 times my required retirement income of $30,000 in today's dollars.
Based on an income of $35,000 my 9% employer sponsored superannuation contributions will be $3,150, less around $470 in contributions tax a year, which is $2,680 a year or $13,400 over the 5 years. That means that outside of super I need to save around $16,600 over the 5 years as well as getting rid of my $10,000 high interest credit card debt. If I commit around $100 in additional payments a week to my credit card debt, I can see that will take just over 2 years to get rid of that. Then, saving $120 a week for the remaining three years will leave me with $18,000 before any investment returns. Easily bringing my net wealth above the $30,000 that I am aiming for at age 30!
The following table shows the dollar amounts for a person starting at age 25 with $10,000 of credit card debt and wanting to retire at age 60 on an income of $30,000.
Four Comments on the Wealth Benchmark Model
1/ The model is proposed as a rough but robust guide to plan realistically for your retirement goals. It would be unwise to read into the model any greater level of accuracy than that. The biggest assumption made relates to the 25% investment earnings in any 5 year period, and you should consider what will happen if this level of investment earnings is not received, particularly in the periods close to your retirement.
2/ If you are under the age of 25, do not be reluctant to start building wealth early! The earlier you start the greater your investment returns will be over time and the sooner you will be to reach financial independence. Don't use the fact that I have assumed a net wealth of $0 at age 25 as a reason to procrastinate prior to age 25, rather use it as a way to motivate yourself to ensure that you are well ahead by age 25! If you actually had one times your retirement income saved by age 25 years, you can say that you are already on track to retire 5 years early!
3/ If you look at the model and find yourself behind, there is no need to panic. You can address this by increasing your rate of saving, working a little longer (ie past age 60) or being prepared to accept a slightly lower retirement income. The important factor will still be that you are making the conscious decision to build your net wealth which will inevitably improve your retirement situation.
4/ If you are close to retirement and well behind financially, you will be able to use the age pension as a safety net to increase your retirement income. Remember, you will still be rewarded with a higher retirement income if you increase your net wealth between now and retirement, allowing your investment earnings to supplement the age pension that you will receive.