If you’ve been making $500,000 a year for a decade as a 40 year old but only have a $1 million net worth, you’re probably a donkey with some serious financial issues. If you’re making $80,000 as a 30 year old but have a $500,000 net worth I’d classify you as a hero who is on their way to bubbles and unicorns!
I’ve written about The Average Net Worth For The Above Average Person that provides charts on where highly motivated people who want to achieve financial independence should be. The only problem with my analysis is that it doesn’t tie income levels specifically in the charts. This post will bind the inextricably important link between income and wealth to ensure as high a chance of financial freedom as possible.
To create a good net worth guide based on income can be very tricky based on variables such as how long someone has been making X income, the return on investment, and the state of the economy. Hence, a more conservative assumption is to replace net worth with savings. Let’s first understand the current state of the world and break down our assumptions.
FINANCIAL ASSUMPTIONS FOR NET WORTH / SAVINGS TO INCOME RATIO
* Low interest rate environment. Interest rates have been coming down since the 1980s and have reached a level where it’s harder to get much lower. The effective Fed Funds rate is at 0.15% and the 10-year yield hit a low of around 1.4% in 2012 and is still under 2.5% in 2H2015. The Fed has already telegraphed they will begin to raise the Fed Funds rate if the national unemployment level gets under 6.5%. After all, the Fed’s job is to keep inflation in check and maximize employment.
Low interest rates mean low risk free returns. This is terrible for savers who are conservative in their investment strategy, but conservative is what we should all be once we’ve built up a large enough financial nut that spits out a perpetuity of income. The S&P 500 is yielding roughly 2% and a basket of dividend focused stocks will probably get you around 3%. As a result, please eliminate the commonly held 4% withdrawal rule and choose something closer to 2%. Remember, the ideal withdrawal rate in retirement does not touch principal.
* Life expectancy extends to 85 for men, 90 for women. We don’t know whether we’ll live longer, but we should conservatively assume than the median life expectancy of 78 currently is too low. The longer we assume we’ll live, the more money we need to have in retirement. It’s better to end up with too much than too little because we can always live a will to give our money away to those in need.
* Retirement age no later than 65. It would be a crying shame to work for 43 years after college and only live until age 78 wouldn’t it? Age 65 is the maximum age for work in my net worth by income model. Ideally, we all reach financial independence much sooner and experience the luxury of the “one more year syndrome.”
* Savings rate is at least 20% with the ultimate goal of saving 50%. You can’t grow your savings and investments aggressively without having a commensurate savings percentage. The goal is to build your financial nut so large that it starts saving more for you than you can save on your own. Ideally everybody should strive to save 50% of their after tax income or more by age 50. The easiest way for most people is to see if they can just save one of their bi-weekly paychecks every month while maximizing their pre-tax retirement plans. Here is a great chart on how much savings you should aim for by age using the expense coverage ratio concept.
* There are no income producing breaks. This is a difficult assumption because so many of us will take time off between jobs to go travel, spend time with family, or start a business. I’m a prime example who has extricated himself out of the work force to give a go at online entrepreneurship. My absolute savings amount per year is much lower, but my savings percentage continues to be high as I adjust my lifestyle and spending habits. Only a small minority of people take work breaks for longer than two years.
* The trend is up and to the right for economic growth. There have always been gains in any 20 year period. With a more collaborative world and the advent of the internet, productivity gains and economic growth should continue. Surely we will see multi-year bear markets again as that is the nature of a cyclical economy. But structurally, the long term trajectory is higher thanks to demographics, inflation, technology, and productivity. All this said, I don’t assume any returns except for end where I allow for +/- 25% changes to the final ratio.
NET WORTH OR SAVINGS BY INCOME RATIO CHART
I was originally going to make this chart very complicated by including an after tax savings rate column, growth rate percentages, effective tax rate assumptions and so forth. Instead, I’ve decided to simplify the chart to highlight a net worth multiple of income goal by age in five year increments. You will also see hypothetical net worth (savings) amounts by age based on $60,000, $100,000, and $200,000 income levels.
1) Focus On The Multiples: The chart is designed to work on any income level above the poverty line. The examples of $60,000, $100,000, and $200,000 income levels and their respective amounts are there to provide visual guidance of what could be. If you’re used to making $60,000 a year for your working career, then you should be use to making a similar or less amount during retirement. Same goes for those who make more.
2) Calculate Your Own Multiples First. It’s better to be conservative and calculate your individual target net worth in case something happens to your relationship or in the event you never find anybody. If you are married, then simply calculate your net worth targets based on your combined income.
3) Each Persons Lifestyle Expenses Are Different: This chart isn’t a one size fits all net worth to income chart. Some people are happy to live very spartanly in the middle of nowhere making it unnecessary for them to have such high multiples. My chart is intended for folks who want to live above average lifestyles without having to worry much about running out of money living in more expensive cities. You may shoot for a higher multiples as well.
4) You Can Expedite Your Net Worth: By simply increasing your savings amounts, making more money, and investing in profitable assets you have the power to increase your net worth faster and retire earlier if you choose. Let’s say you make $60,000 a year and have a target of $1.2 million in net worth by age 60. According to the chart, if you can find some way to increase your income to $200,000 and maintain your savings/investing habits, you will save 20 years of work and retire by 40. Easier said than done of course, but the possibilities are there.
5) The Exit Multiple Target: Once you hit about 15X your annual gross income as your net worth or savings figure, you can seriously start thinking about retiring or doing something else more enjoyable. You will have to contend with various other assumptions including whether you include your primary residence in your net worth, whether you still have a mortgage, and if you have alternative streams of income. My hope is that everybody works on passive income streams during their wealth accumulation phase so they don’t need as much or any income in retirement.
It’s very important to have some idea of target net worth figures because it’s not so much what you earn, but what you save. There are countless stories of people making huge salaries only to piss it away on frivolous things and end up with very little to nothing. This is why I highly encourage everyone to have around 30% of their net worth in risk free assets just in case everything goes to hell.
Continue to actively track your net worth progress a couple times a year. Targets will help you adjust your finances accordingly and increase your chances of reaching your goals much faster than others who do not bother. You should also consider calculating your net worth by your realistic living expenses to come full circle.
While I was working I had a target of reaching a net worth equal to 20X a sustainable income by age 40. Instead, I left the workforce with a 15X multiple at 34 because I figured out how to raise my multiple to 18X in a matter of months by negotiating a severance package after 11 consecutive years at one company. I’m still 2X multiples short of my 20X target, but given the flexibility to lower my cost of living and the potential to make money through alternative means I’ll be alright. One of the things you’ll discover once you’re free is how many more opportunities come to light!
Recommendation To Build Your Net Worth
The best way to build wealth is to get a handle on your finances by signing up with Personal Capital. They are a free online tool which aggregates all your financial accounts on their Dashboard so you can see where you can optimize. Before Personal Capital, I had to log into eight different systems to track 28 different accounts (brokerage, multiple banks, 401K, etc) to track my finances. Now, I can just log into Personal Capital to see how my stock accounts are doing, how my net worth is progressing, and where my spending is going.
One of their best tools is the 401K Fee Analyzer which has helped me save over $1,700 in annual portfolio fees I had no idea I was paying. You just click on the Investment Tab and run your portfolio through their fee analyzer with one click of the button.
Finally, check out their newly launched Retirement Planning Calculator for 2016! The calculator uses real data you’ve inputted to calculate using a Monte Carlo simulation model what your retirement future might look like. I highly suggest you run your calculations yourself with realistic expense and income variables. It’s all free after all.
There is no better free online tool that has helped me stay on top of my finances more than Personal Capital. It’s important to aggregate all your accounts to get an entire overview of your net worth to make proper changes. It only takes a minute to sign up.
Updated for 2016 and beyond