Publisher: The Penguin Group. Hard cover. 257-pages. Price: $26.
Author: Charles Farrell, JD., LL.M., investment adviser with Northstar Investment Advisors, in Denver. He writes the “Retirement Roadmap” column for CBS Moneywatch.
Review: “Your Money Ratios” sings to me! For someone who loves using ratios such as the 1/10th rule for car buying, and 30/30/3 rule for home buying, I absolutely adore this book. Charles’ writing style is very balanced and easy to understand. When it comes to math, many people, including myself fall asleep. But, if you can just do simple division and multiplcation, this book will keep you on the right path towards financial security.
Charles’ “Unifying Theory of Personal Finance” is his core philosophy that all decisions you make should help move you from being a laborer to being a capitalist. In other words, make money work for you, and not the other way around. It’s important that with every single monetary decision you make, you ask yourself will this help you become a capitalist or not.
Capital To Income Ratio
The first ratio Charles introduces is the Capital to Income Ratio (CIR). Capital is defined as the savings in your 401K, IRA, annuities, CDs, cash value of your life insurance, savings, equity in commercial and rental real estate, and the fair market value of any business interests. Capital does not include the equity in your primary residence because it does not generate income. The real return of your home is the rent-free use of the property once you pay off your mortgage.
The underlying goal is for everyone to have a CIR of 12 by age 65 i.e. $1.2 million in capital if you average $100,000. With a CIR of 12, one should be able to retire financially secure while living off 80% of your pre-retirement income due to the returns from capital and social security. While working we probably live on about 60% of your actual income due to expenses such as one’s mortgage, which will no longer be there when we retire.
Your finances hit a tipping point when your Capital to Income Ratio hits 2. At a CIR of 2 your earnings from you capital will generally add more to your wealth than the amount you save each year. Over a 40yr savings cycle, you contribute 30% 70% are from earnings.
The Savings Ratio
To get to a Capital Income Ratio of 12, Charles highlights on two savings rates: Save 12% of your annual income ever year from ages 25-40, and save 15% every year after wards. The math works, and obviously the math works even better if you can save more of your annual income.
To clarify, the Charles’ 12% and 15% savings ratios include your 401K contribution.. Charles believes that your 401K is key to financial independence due to employer matches and tax free contributions.
I challenge readers to max out their 401K and save an additional 12-15% of their gross income. Mentally write off your 401K amount, and pray it’s there at age 59.5. My strong belief is that your net worth is an illusion, except for the cash and most liquid of assets.
Your Debt Ratios
One needs to differentiate between income-producing debt and income-reducing debt When you take on debt, you need to leave enough for you to meet the savings ratio Owning a home and paying of your debt increases your retirement income and helps move you from laborer to capitalist. “Deemed Income” is the investment income you get to keep in retirement because you don’t have to use that income to pay a mortgage or rent.
Education debt, is good debt, but aim to keep it to 75% or less of your average 10 year gross income. Financially, it is better for your kids to take on the debt than you provided they stick to the Education Debt Ratios.
Charles, like others believes there is an education bubble. Tuition costs are ridiculous and will eventually fall because income growth doesn’t support the cost. Charles advises not saving for your kids education before you save for your own! If you don’t save enough for yourself, your kids inherit your financial burden and have to take care of you. Your financial independence is a great gift to your kids.
Your Investment Ratio
It’s all about playing offense (stocks) and defense (bonds) to come out ahead. Charles recommends a permanent 50%/50% allocation your entire working life. I find this too conservative. I like following your age as a percentage to allocate to bonds i.e. if you’re 35, somewhere around 35% of your investments are in fixed income securities.
Charles is super risk adverse because he wants to avoid big losses. As an investment adviser, and given his age, I have a feeling he has seen tons of carnage over these past two investment cycles. A 50% portfolio decline requires a 100% increase to get back to even. A 80% portfolio decline requires a 400% increase!
Social Security – The Point of Contention
Charles fears Congress will go overboard in fixing SS, and create one large wealth-transfer. Despite the “fix”, SS will survive. Lower paid workers get much more out of the system than higher paid-workers, based on their actual contributions. It’s important for everyone to understand the basics of SS, to not change the program from a long term retirement program into a welfare program.
Your FICA tax is 7.65% from you, 7.65% from employer of which 12.4% goes to SS, and 2.9% goes to Medicare. You need to work for at least 10 years for a covered employer before you can receive benefits. Cap is on $106,800 of the income you pay, thank goodness for many. SS adjusts for inflation is great. And if you’re married, your spouse has the right to benefits equal to the higher of his or her OWN benefit, or one half of yours. Not bad!
By the way, if you were born after 1960, the full-retirement date to receive social security benefits is 67! You can decide to take reduced benefits starting at age 62.
“Your Money Ratios” has the potential to be one of 2010’s best sellers in the personal finance space. I love everything about the book, from the tone of the author, to his simple instructions, to the way the book is packaged. There’s no doubt in my mind that if you follow Charles’ instructions, whether you are 25 or 45, you will be able to reach financial independence by 65. Go to your local bookstore or Amazon and check it out!
Go to www.yourmoneyratios.com, type in the code 778811 to check out your ratios and see where you stand!
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