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The current issue of the Journal of Financial Planning
features an article by attorney Charles J. Farrell, who came up
with personal
financial ratios. They provide concise benchmarks that consumers
could use to see how they're doing financially at various stages
in their lives.
The idea of using ratios to make evaluations is not new. Stock
investors use guidelines such as stock price relative to earnings
(P/E ratios) to determine if a stock is cheap or overvalued.
Personal finance ratios
Why not apply the same concept to individuals to determine how their
personal finances are doing? The three ratios that Farrell devises
are savings to income (S/I), debt to income (D/I) and savings rate
to income (SR/I). His ratios correspond with benchmarks people should
attempt to reach between ages 30 and 65.
The beauty of the system: The ratios can apply to everyone at all
income levels, since an individual's own income is the denominator
in all the calculations.
"The objective of the ratios is to help individuals
move from a situation of having high debt and low savings at the
beginning of their working careers, to one where they have high
savings and no debt at the end of their working careers," he
says.
The assumptions
Farrell makes certain assumptions: a 5 percent rate of return on
investments, a 5 percent withdrawal rate for retirement savings
beginning at age 65, and savings that will replace 60 percent of
pre-retirement income (so that when added with Social Security,
an 80 percent replacement rate is achieved). The savings rate is
uniformly 12 percent beginning at age 30 until retirement age. (You
may need to adjust that assumption to fit your own situation. For
example, if you started saving for retirement at age 35 instead
of 30, you'd need to increase your savings rate). The goal is to
accumulate 12 times your pre-retirement salary by age 65.
If you're feeling a bit smug because your net worth is high, due
largely to appreciation of your home's value, Farrell's calculations
may serve to humble. He doesn't count home equity as part of savings
because people need someplace to live. Unless you plan to downsize,
it shouldn't be factored in.
At age 30, the savings-to-income ratio is 0.1 (10
percent), the debt-to-income ratio is 1.70 or 1.7 times income level.
At age 50, the savings-to-income ratio is 4.5 and the debt-to-income
ratio is 0.75.
So, how do we interpret the ratios for the 50-year-old?
Assuming an income of $100,000 (to make the calculations more transparent),
boomers at this age level should have savings of four and a half
times income, or $450,000. Total debt should represent no more than
75 percent of income, or $75,000, including mortgage, credit cards,
car loans, etc.
Don't be discouraged
Remember, these are benchmarks toward which we should strive. Consider
them tools to increase your awareness of your financial standing
with respect to your goals.
Use them to realign your priorities. For example,
if you are in the market for a new car, maybe you should decide
against the $40,000 sport utility vehicle with leather seats, and
instead opt for a smaller, more economical $25,000 model. Think
you need a bigger home? Maybe you don't. Maybe instead you should
pay off the home you have now and defer extra money into your retirement
account.
What troubles me is that nearly 20 percent of the CFA/FPA survey
respondents have saved less than $10,000 toward retirement -- and
more than half of them are age 45 and older.
As my yoga instructor recently said to our class,
"You've got to start from where you are ... because you have
no other choice."
So yeah, it's not only possible, it's downright feasible to save
up hundreds of thousands of dollars for retirement. Make your own
fortune by steadily contributing to your retirement plan. And do
let go of all expectations of getting wealthy by winning the lottery.
If you have a comment or suggestion about this
column, write to Boomer
Bucks.
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