One of the most tricky things about personal finance and retirement saving is having clarity on whether you are on track to hit your retirement goals. Have you saved too little and therefore are “behind schedule” on our retirement savings? Have you saved more than you need to and are “ahead of schedule” on our retirement saving? And exactly how far or behind or ahead are you?
Enter Dr. Thomas J. Stanley, author of “The Millionaire Next Door” who came up with a simple equation that can be used as a rule of thumb to determine how much wealth you have created given your current age and income.
Put simply, the wealth equation states that a household’s wealth should be equal to 10% of the age of the highest income earner in the household multiplied by the household's combined income.
Wealth Equation= (10% X Age of breadwinner) X Household income
Let’s illustrate this with an example, let’s say you are 45 years old and you have an income of $55,000 and your spouse is 49 years old and has an income of $60,000, how much wealth should your household have?
Wealth equation= 4.9 (10% X 49) X $115,000 ($55,000+$60,000) = $563,500.
According to the wealth equation, your household net worth should be $563,500. According to Dr. Stanley, you would be a "prodigious accumulator of wealth" if your net worth is equal to what the wealth equation says it should be.
The wealth equation does not work for young people
Dr. Stanley acknowledges that this rule of thumb is intended for those over the age of 40 to gauge how effective they have been at saving and growing their net worth in their 20’s and 30’s.
The wealth equation tends to overestimate how much wealth you should have accumulated for young people, particularly for young people with a high income.
Let’s quickly review another example of the wealth equation to see why that is. Let’s say Jean who is 27 and single just finished her graduate degree and landed a job that pays her $85,000 per year.
According to the wealth equation, Jean should have a personal net worth of $229,500 (27 X 10% X $85,000). Given she just finished school and likely has student loan debt, it is not very reasonable to expect her to have amassed a net worth of nearly $230,000.
A more personalized alternative to the wealth equation
The main problem I have with the wealth equation is not that it overestimates how wealthy young people should be but its seemingly arbitrary nature. While it makes me feel good to be considered a "prodigious accumulators of wealth", it doesn't tell me whether I am on track to hit my personal goals.
Let's return to our example of the 49 and 45-year-old couple making $55,000 and $60,000 respectively. If their goal was to retire by the time the older of the two reaches age 65 and they wanted to live off 70% of their pre-retirement income does their current net worth of $563,500 put them on track to reach that goal?
Let's dive into the numbers to find out.
Desired annual income in retirement: $80,500 ($115,000 X 70%).
Total retirement savings required to provide desired retirement income: $2 million (using the 25 times rule).
Other assumptions
Their current wealth of $563,500 can be used to fund their retirement.
Both individuals have a workplace Defined Contribution retirement plan where they and their employers each contribute 5% of their gross income.
They earn a 5% rate of return on their investments.
I'll assume they have no other retirement income apart from their personal wealth.
They have 16 years to accumulate an additional $1.45 million in wealth to hit their retirement goal.
How much they need to save each month
Total monthly savings required: $2,593.
Amount already contributed into their workplace retirement plan: $672.
The additional amount of personal savings needed: $1,922.
Takeaways
The wealth equation is a very quick and simple way to measure where you stand on your financial journey. However, as is often the case the cost of simplicity is the loss of accuracy. Since the wealth equation does not take into account any of your financial goals it cannot give you an accurate representation as to whether you are on track to achieve those goals.
In the example of the 49 & 45-year-old couple, the wealth equation stated they would be "prodigious wealth accumulators" with a $563,500 net worth. However, when we accounted for their current savings and compared that to their retirement goals we found they had a $1,922 monthly savings shortfall.
By using a more complex calculation that is based on your financial goals you can get a more accurate reading on whether you are on track to hit those goals.
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions