Friday, November 30, 2007

Metrics to evaluate Personal Finance Progress

I noticed on some other PFblogs several PF related ratios that are posted on the sidebar. Ratios are helpful as metrics or benchmarks – something to help measure your progress. It’s a great motivator and I can’t wait to run the numbers.

Savings to Income = S/I
If your interested in PF, you have probably calculated your net worth. If not, get out a spread sheet and start tallying up everything you own (exclude your home) and subtract all debt. Now take that number and divide by your total before tax income. For example, if you have a net worth of 500K and income of 100k, the ratio is 5. For reference, a rule of thumb often touted by Certified FPs is a S/I goal of 12 to begin retirement. The number 12 is based on a 5% withdrawal rate that would equate to an income that is 60% of your final salary. Add Social Security and/or pension benefits to that and you retire with approximately 80% of your final income. My S/I = 9.9. Lets try another one.

Debt/Income = D/I
I like this one, because I have no debt. My credit card is paid off every month, my truck is free and clear and I have paid off my mortgage ( we can argue the pros and cons about that later). So D/I = 0.

Savings Rate to Income = SR/I
This is a little bit sketchy because only pre-tax savings are to be included. For instance, add up any contributions to an IRA or 401(k) plus any company matching and divide by income.
IMHO, I think all savings should be included, even after tax savings. In fact, after tax or non sheltered savings are the key to early retirement. Having an over funded 401(k) that can not be utilized without penalty until you are age 59.5 is not going to help you retire in your 40’s. Including all savings increases my SR/I substantially to 59%.

Another useful ratio, Passive Income/Expenses = PI/E
Passive income includes income only from capital gain distributions and dividends. It excludes salary, capital appreciation, one time sales, etc. My PI/E = 95%.
My goal is to live off of passive income, only. Some margin is necessary to allow for variations in capital gains that are distributed based on fund performance, turnover, and other fund manager controlled activities.

And finally some Wealth accumulation ratios
A Wealth Accumulator or WA from the Millionaire Next Door is defined as a net worth that is equivalent to or greater than 10% of your salary * age. While PAW or prodigious accumulator of wealth is quantified as two * WA. Let’s calculate the WA value and then divide by net worth to get a WA or PAW ratio. When I first started tracking this metric 6 or 7 years ago, I was not quite to the PAW level. It gave me something to shoot for - a rabbit to chase. My current PAW ratio = 115%

I plan to incorporate these ratio calculations into my net worth spreadsheet. The spreadsheet is used to track my assets and their performances and is updated on a monthly basis.

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