Wealth to Lifetime Earnings Ratio: Part 1

This is Part 1 in a short series exploring the concept of lifetime earnings vs. net worth.  It’s pretty heady stuff so I’m breaking it up into a couple of linked posts. 

What is your Lifetime Wealth Ratio?  How good are you at converting earned income into net worth?  I first read about the wealth to lifetime earnings ratio on a Lifehacker post that was quoting Budgets Are Sexy.  It’s a very powerful way to look at your personal finances.

Back up a second.  What is net worth? Net worth is defined by accountants as assets less liabilities.  For normal folk that means, all the stuff (investments, house, cars, etc.) you own minus what you owe to others (student loans, mortgage, credit cards, etc.).

So, let’s get started.  Total up your assets (hypothetical values taken from here):

  • House: $800,000
  • Retirement accounts: $45,000
  • Cars: $30,000
  • Company Stock: $20,000
  • Mutual Funds: $5,000
  • Total assets: $900,000

Next, total up your liabilities:

  • Mortgage: $250,000
  • Car Loans: $40,000
  • Credit Card Debt: $10,000
  • Total Liabilities: $300,000

Subtracting total debts (liabilities) from total assets ($900,000 − $300,000 = $600,000), and we can see that this household would have a net worth of $600,000!  That sure sounds like oodles of cash piled in a giant vault somewhere, doesn’t it?  Using US census data from 2011, we can get a rough idea of where this household falls within the US population.  Note that this is all US households (not adjusted for things like head of household age, location, etc.), and this example would fall within the top 13%.

2011 Census Net Worth Distributions

Distribution of US household Net Worth.

And that’s why I think net worth is so interesting.  Earned income (aka salaries or Benjamins) is great, kind of like sugar.  But unless you convert it into something useful, it will be gone.  And you will be left with nothing but the need to fill up again with a quick hit on payday.

It’s tough to really get a good view of the what people are really worth.  The census buckets above are really coarse, and there’s no link to earned income.  However, there is a pretty cool view (yes I said that about a census table) of the different types of assets that wealthy vs. poorer households own.

Net Worth By Asset Type

2011 US Census breakdown of median net wealth by asset type

Keep in mind that the upper part of the graph is all median values for the category.  Nevertheless, seeing the total dollars visually displayed threw me for a loop, especially when you think that 45% of the US population has less than $50,000 to their name.  The goal for me was to see how rich folks allocate their dollars.  My key take away: diversify your assets.

I was floored by how many folks in the upper brackets have rental real estate in their portfolios and yet how small of a proportion of their asset base it remains.   I’m also shocked at how little is saved in retirement accounts vs. how much equity we have in our homes.  Finally, the amount Americans have “invested” in their automobiles is shameful stunning.

There is of course a chicken and egg problem here. We cannot say which came first: income producing assets or earned income. The results are pretty clear: wealthy folk have a much larger share of their wealth in wealth-producing assets. So, I’m happy to expand on that theme and put my (biased) interpretation on the data.
1) Buy fewer Maserati’s and more stocks/bonds.
2) Fully fund your retirement accounts (plural!)
3) Own your own (modest) home
4) Buy one or more positive cash-flowing rental unit(s)
5) Consider alternative investment strategies once you have covered the basics

6) Diversify your income sources

 

Next up: Lifetime Earnings.  Followed by the actual Lifetime Wealth Ratio.   Stay tuned!

Are you surprised by the asset category differences? Where does your household fall on the net worth distribution? What strategies are you using to grow your net worth?

 

How to Prepare for a Layoff

With the Great Recession officially ending in June 2009, the US economy is almost 7 years into its recovery as of May 2016. Based on recent history, that’s a long run of good times a rollin’. How far in? It’s tough to tell.  The Bureau of Economic Research keeps track of US economic cycles.  Because their announcements tend to lag a peak or a trough (by up to 21 months!), let’s take a quick look at recent historical cycles to get a crude sense of where we might be in this cycle.  If you’re an optimist, you can make a case that the US economy may still be peaking:

GoodTimesYetToCome

If you’re a pessimist, you can argue that the economy is already in decline and we’re heading for the bottom of our next economic cycle:

GoodTimesBehind

Regardless of whether you think the economic punch bowl is half empty or half full, if you work for an employer, you have some risk of a layoff to contend with. So, what is a well-intentioned employee to do!?

Let’s set aside brown-nosing, jumping ship, and prayer as possible strategies to prepare for a layoff or other disruption to one’s primary income stream (This is a financial blog after all).

As I see it, there are two basic approaches: defense and offense.

Defense:
Cash

Cold, hard cash (or in a savings account). There is no substitute for a well-stocked emergency fund.  Conventional wisdom says that when looking for a new job, plan for about 1 month for each $10,000 of compensation.  If you want a $100k/yr job, be prepared to spent ~10 months to find it.  …so, how big is your emergency fund?

HELOC

As I understand it, a Home Equity Line Of Credit is like an open credit card against the equity you’ve built up in your home. Why would anyone be interested in such a critter?

  1. It provides a leveraged way to boost your emergency fund
  2. The interest costs are type far lower than a credit card.  On the order of 3 to 6 percent these days.

Unfortunately, there are also some downsides:

  1. You could lose your house as the HELOC collateral is your home.
  2. you need to demonstrate financial stability now. It’s tough to get a bank to approve a HELOC after you’ve suffered a financial perturbation already
  3. You will be charged interest on your outstanding balance until you pay it back
  4. There is an upper limit to how much of a line of credit you can obtain. How much equity you’ve built up in your home vs. market value is an influential factor.
  5. The interest rates are adjustable ~monthly, introducing volatility

Other Loans (e.g., Personal or Student)

There’s a couple of other loan options.  Personal loans are just that: loans for any personal use.  The lending office will be looking for verification of your income, so if you want to pursue this option (e.g., HELOC not available), get started while you still can show steady income.  Interest rates can vary but be between 6 and 9 percent currently (it’s good to be the bank, isn’t it!?).   If you are currently even a part-time student, you have a pretty cool option available to you: interest deferred student loans.  You’ll have to fill out a Free Application for Federal Student Aid (FAFSA).  Rates vary between 4 and 6 percent these days.

Credit cards

This is definitely a fall back option. I think an extra credit card that is largely unused, possibly with a single bill that auto pays each month, is a great idea. It can help boost your FICO credit score by lowering your percent of revolving debt. The minute you have a revolving balance at 10, 15, or 20% interest, you’re in trouble.  But, for a short term disruption, it might enable you to pay for essentials.

 

Cut Costs

If there is a pending disruption to your earned income stream, now is a great time to review your current expenses and trim what you can.  Cable, gym memberships, other monthly entertainment subscriptions (Netflix, Hulu, Spotify, Kindle Unlimited, gaming, etc.) are all candidates.  They may not be major drivers of your budget, but they’re easy targets, and they’re pretty quick to cut.  Reduce/negotiate your wireless data plan (we’ve cut ours from almost $130/mo to $85/mo!) Bigger targets of opportunity are certainly out there: housing, transportation, etc.  But, I’ll assume they’re roughly fixed for most folks in the short run.

Offense

Diverse Income Streams

Of course, this is one of my favorites (and a prime theme of this blog).  If 95% of your income derives from your day job’s paycheck, losing that income stream is highly disruptive.  If 20% of your income comes from your day job, it’s not such a big deal.  When you have enough income from other sources, you reach the F.U. Point ℠ (that’s “Freedom Uttained”).  Hustle.  Start a business.  Start a website.  Start now.

Unearned Income

Use a portion of your current net worth to generate unearned income.  We’ll revisit this topic in much more detail in future posts.  But, here’s a quick breakdown:

  1. No risk: Set up a CD ladder to earn a bit of FDIC insured interest income on a regular basis.  These days, this amounts to a pittance, but if you shop around, you can find rates a bit better than a high-interest savings account.
  2. Minimal risk: set up a bond ladder or buy into a bond fund (with quality bonds) directing interest payments to your checking account.
  3. Higher risk: buy & hold dividend stocks directing dividends to your checking account.
  4. Crazy risk: Peer to Peer lending where you become the bank to other folks (given that the context for this post is planning for a perturbation in your earned income, this may be folly).

Jump Ship

I said I was going to exclude this from the list, but I’m bringing it back anyways.  If you’re in the fortunate spot where you are finding out about a layoff before it hits, start looking for a new gig now.  Get that resume updated and tap your internal and external networks.

Yes, I said internal…

Not all parts of a company experience a cull in the same way.  You might be able to transfer or rotate much more quickly than finding a new opportunity externally.  In parallel, leverage your external network to see who can use your awesome skills.

A special shout-out to my friend, Dan for providing the inspiration and framework for this post.

Returns Matter

 

We’re all in a race against the clock.  How we handle the ups and downs sets us up for long-term success … or an ulcer.

Takabisha_roller_coaster

Sometimes, the path to financial freedom can be a little scary.  Photo Credit: Alex Brogan

Regardless of whether or not you work for someone else for your living, how we deploy our available resources over our lifetimes matters greatly. Most folks are familiar with the idea of compounding interest: where over enough time, your money makes a tremendous amount of money without you having to do much additional work. Once you have enough money to last your remaining lifetime, you’re financially free. So how do you get there? Making payday loans? Putting all your savings into a big pile of cold hard cash under your mattress or more comfortably into your closet?

Let’s explore the relationship between risk and reward.

Starting with the classic compounding interest chart from high school, we see a hypothetical pathway to awesomeness. 7% average returns from the time you start putting money into the Wall Street piggy bank. Put your hard earned cash into a bunch of 3-4 letter acronyms representing businesses. Add a bunch of time, and the road to Millionaire status couldn’t look simpler, right?

100 over 87 ave yrs

What this view fails to consider is volatility. Here’s what actual annual returns look like for the US market. Not such a smooth pathway is it?

100 over 87 real years

OK, I admit that I played with the scales to make this look more equivalent.  Here’s the first two plots overlaid on top of each other.  Now you start to see why the stock market has been long-considered one of the best investment vehicles around.  Cool, huh!?  The point remains: you had to have some serious gumption to not sell as things were crashing in the late 90’s/early 00’s and 06-09.

100 over 87 yrs real vs. ave

Don’t feel like putting your investment dollars on a roller coaster?  What if you want guaranteed returns? Just about the safest investment around is a CD. The FDIC guarantees all investments for up to $250k. In exchange for that nice safe blanket, you get low returns. Currently 0.5%-1.5% depending on the term. Long-term, CD rates look like this:

CD Rates

Long-term CD rates. Source: Bankrate.com

Where CDs may have once provided a decent return %, it’s now tough to lock up your funds for 12 months to 5 years in order to attain rates greater than an online savings account. Probably not the fastest way to financial freedom, right?

CD balance growth over time

 

What if you are willing to take on a bit more risk than a CD?  For example, it’s quite likely that the US will continue to meet it’s debt obligations.  US Treasury bonds are historically one of the safest investments out there, especially relative to other countries with less stable economies or companies.  Understanding how to assess bond risk and pick out what debt to invest in is beyond the scope of this post, so lets just stick with medium term US debt (10-year US Treasury Bonds). To simplify things, we’re also going to assume that we’re investing our $100 into a fund that costs nothing and lets us take advantage of annual rate changes while re-investing the interest.

TBonds over 87 real yrs

 

 

Get to the point already, right!?

Let’s put it all together and see which investment strategy gets us closer in a hypothetical race.  Let’s assume that most folks work about 40 years in their traditional 9 to 5’s.  We’ll start with an initial investment of $1000.  That’s right, $1000…and that’s it.  If you invested $1000 at age 22, what is the theoretical balance for each when you’re 62?  So, we’ll take the most recent couple of years for each of our asset classes (CDs, Bonds, and Stocks) and hold those interest rates constant for 40 years (I know, it’s a contrived example, but it’ll illustrate the point).

40 year race

And the winner is…

 

As expected, higher returns result in a higher ending balance at the end of one’s career.  And, that’s the take-away: over a long enough time frame, maybe the short-term risk associated with asset volatility can be discounted.  Maybe we spend too much time worrying about 0.25 point returns for a 60 month CD at one bank vs. a high-yield savings account.  Instead, perhaps we should acknowledge that we are our own worst enemy.  Our emotions when news headlines blare negative returns, tempt us into making bad decisions.  We want to, “stop the bleeding.” We sell everything.  In so doing, we typically take a big loss and miss out on the next market rebound.  John Bogle might say just invest in the whole market regularly.  Hold your investments for the long term.  Keep your costs low.

I would distill that into an expression from Las Vegas and simply say, “let it ride!”