Laura Rowley Money & Happiness

Laura Rowley Money & Happiness Laura Rowley, Money & Happiness The Question of Measuring Financial Progress by Laura Rowley Email this Page IM this StoryBookmark this StoryAdd to your Del.icio.us accountDigg this StoryPrint this Story Very Good (81 Ratings) 3.0617282/5 Posted on Wednesday, November 18, 2009, 12:00AM I recently spoke with a professional financial coach about the value of monitoring your net worth. As many readers know, net worth is all of your assets minus your liabilities. Imagine you sell everything you own -- home, car, etc. -- and add that to the value of your cash savings and investments, such as stocks and bonds. Then subtract everything you owe -- mortgage, student loan, auto loan, credit card debt, etc. That's your net worth. My coaching friend plugs all this information into a software program and monitors her net worth on a monthly basis. Obviously, as you pay off debts and accumulate savings, your net worth rises. She feels this is the best way to monitor financial progress. I used to agree, but I have given up tracking my net worth, because it turned into a feel-good exercise that was disconnected from my goals. For instance, we have been saving for years to cover the cost of our children's college educations. This is a hefty liability, and right now, those savings exaggerate our net worth. In 15 short years, when all three kids have graduated from college, the money will be gone. (Unless the hereditary gods smile on us, and they get basketball scholarships like their dad did. But we're not banking on their jump shots.) Philosophically, of course, we'll have the "net worth" of educated (and with any luck, gainfully employed) children. But it's not really fair to include college savings in our net worth when they are, for all intents and purposes, spoken for. "That's intuitively correct," agrees Charles Farrell, principal with Northstar Investment Advisors in Denver. "It's as if a company looked at its assets and included the pension plan it owes to employees. You can't do that. It's not net worth that I consider important, but 'am I going to have enough money to support myself in retirement?'" Farrell says a focus on net worth can distract from the primary goal in personal finance, "to create a pool of assets from which you can generate income for your retirement years," he says. "So whatever supports that goal can go into your net worth, whatever doesn't really should be looked at differently." For instance, if someone buys a $40,000 car, it's an asset in the strict sense of net worth, but it won't help you retire; the same is true of a big house. "If your house goes up in value and you don't plan on moving, all it does is increase your property taxes," says Farrell, adding that the real value of a home is that you have a place to live for free in retirement once the mortgage is paid off. "If you bought real estate in California in 1985 and sold 2003, you got lucky," he says. "But you can't rely on luck as part of your planning." Thus instead of monitoring net worth, it makes more sense to break out major financial goals, prioritize them and monitor progress toward each one. But how do you measure progress and ensure your targets don't conflict or compromise retirement savings? Farrell attempts to address those issues in his new book, "Your Money Ratios: 8 Simple Tools For Financial Security," which will be published in December by the Penguin Group. The book offers some fairly simple calculations to give people a sense of whether they're on track to meet their goals based on income and age, and still save enough to maintain their current lifestyle in retirement. Farrell first described a capital-to-income ratio for retirement, which calculates the savings required based on earnings and age, in the Journal of Financial Planning. (I wrote about it in this column.) In his book, Farrell adds several other ratios, including: A mortgage-to-income ratio that estimates the maximum level of mortgage debt someone should carry and still have money left to set aside for retirement; An investment ratio, which suggests how much of a portfolio to put in stocks versus bonds; An education-to-average-income ratio, which determines the amount of education-related debt an individual can safely rack up based on expected earnings after graduation. Why base financial goals on ratios? Farrell says the inspiration came from corporate finance, where "we use ratios all the time to analyze companies on the equity side or fixed-income side," he explains. "If you look at a number of different ratios it's a very efficient way to boil down a huge amount of data and get a good picture of company's finances." The difference in personal finance is that those numbers must change over time. "A company's debt-to-capital ratio might be the same in 1980 and in 2010 and that's okay, but in personal finance you have a goal," he explains. "At some point you stop earning income and have to live off earnings from assets, and that requires understanding of how ratios change over time." Keeping the Right Ratios What I like about the use of ratios is that it imposes discipline on emotional spending decisions. When you do the math based on specific goals, real household income and exact time frames related to age, it becomes crystal clear that you really can't afford to blow out the back of your home to expand the kitchen, no matter how attractive or tax-deductible the financing may be. At minimum, such calculations help consumers avoid the personal finance debacles that come from winging it (which tend to lead to larger economic fiascos that hurt everyone). Critics suggest such simple calculations aren't helpful, because every household's situation is unique. In the book "Spend 'Til the End," for example, authors Scott Burns and Laurence Kotlikoff, a Boston University economist, advocate "income smoothing" -- taking on debt when you are young and making very little, and paying it off when your income peaks, to prevent starving in your 20s and oversaving in your later years. For example, a couple with six kids should theoretically save less for retirement than a single person, because the former will experience a sharp drop in expenses when the kids leave the nest. But Farrell argues that effective income smoothing demands accurate predictions about future earnings (a tough task given increasing income volatility). "I can't tell you how many people say what they think they'll make in the future and never make it," he says. "The ratios benchmark off the reality that you're living today -- that's what keeps the discipline. If your income pops up, you're now behind on the ratio. What that tells you is you don't have the assets to support that new lifestyle in retirement." To maintain the higher-income lifestyle in retirement requires ramping up savings, so if someone constantly refers back to the ratio they can stay on track. Moreover, suggesting that a little debt is acceptable in your 20s is kind of like suggesting you can be a social smoker in your 20s. For some people it will morph into a nasty life-long habit. "If you don't start (saving) when you're younger, you're highly unlikely to wake up one morning and do it," Farrell argues. "It's sad when you see people get to the point when they are no longer viable in the workforce and don't have the assets to support themselves. It's a serious business, and you have to treat it as a life-long endeavor."