Wealth: Where Are YOU Headed? (Chapter 4)*

Few people formally plan much in their lives. Usually, that shows they don’t know where they are going. Living life without a plan is analogous to sitting in a drifting boat. You know the direction of the drift, but not the ultimate destination. Words: 1802

Before reading the following please read (here) the Preface and Overview of the book WEALTH IF YOU WANT IT on wealth creation by “Monty Pelerin” (a pseudonym) of EconomicNoise.com.

Living life in this manner is self-selected ignorance. It is neither wise nor necessary. Two issues are crucial to changing this situation:

1. Defining where you are today.
2. Defining where you are drifting to.

WHERE AM I NOW?

Your current location is simple; you already know that. It is your net worth, calculated back in Section 2.2.1. Even if you read slowly, chances are that hasn’t changed. If you haven’t calculated it yet, please do so now.

WHERE AM I GOING?

To determine where you are going requires an understanding of income and spending patterns. This information provides information about where your boat, left unattended, is drifting.

DETERMINING THE DRIFT
Gather two or, preferably, three years of financial information. This information should include bank statements, credit card statements and income sources, at a minimum.

Once collected, perform a forensic review of the data, which accounts for every dollar. That includes income and expenses. Do this for each year.

CASH FLOW STATEMENT
Construct an income statement (actually a cash flow statement) for each of the years. Group your spending by major category, by year. Categories like rent, auto expenses, food, utilities, clothing, entertainment, debt payments, etc. are typical. Add additional ones if necessary. Create a “Miscellaneous” category for odd-ball, tough-to-classify, spending. You must account for all dollars!

Each year has its own column. Income is the first category. Summarized expenses by category follow income. A spreadsheet (electronic or paper) like this one is appropriate:

YEAR 1      YEAR 2      YEAR 3

TOTAL INCOME
RENT
FOOD
ENTERTAINMENT
DEBT PAYMENTS
MISCELLANEOUS
TOTAL OUTFLOWS
NET INFLOW/(OUTFLOW)

You may add or delete categories to accommodate your situation.

When finished, add the spending and subtract it from income for each column. This number represents your cash flow by year. If the number is positive, it represents savings. If negative, it represents dis-saving
(spending more than you made).

RECONCILIATION
Reconcile your calculations to ensure there are no omissions or math errors. Validate the results by answering these questions:

1. If savings occurred in a particular year, where was that money placed?
2. If dis-savings occurred, how did you fund it?

The numbers must reconcile because this is the base of all future calculations. It is mandatory that it be correct! If you cannot reconcile the numbers, get help. The help need not be professional. Your spouse or a friend will probably be able to identify the issue(s).

Do not proceed until you have reconciled these numbers.

ADJUSTMENTS (HOPEFULLY NONE)
Only after reconciliation of the numbers should one consider adjustments. Unusual and non-recurring items might require adjustment.

I hesitate to offer this option because adjustments should rarely be necessary. The option leads to abuse, intentional or otherwise. Most of us are optimists, seeking a rosy future (at least on paper). Adjustments open the door to false and optimistic projections. For example:

• Consider a “major” medical expense like the removal of an appendix. Is that a non-recurring event? Medically, it is because your appendix cannot grow back. Financially, it probably is not.
• You have other body parts which will present “issues” in the future. Financially, the event is likely a recurring one. (That you are using two or three years of historical data enhances the probability of finding such so-called adjustments, but also dampens their effect. It also increases the chances of new ones occurring.)

ADJUSTMENT ABUSE
The problem with adjustments is that they bias toward improvement (i.e., improving savings). Rarely are non-incurred expenses ever considered as add-backs to expenses. For example, major auto repairs or home repairs might not have occurred last year but are routine. Few adjust by adding back such expenses.

Adjusting income downward is also rare. Few lower the income projection when it contains excessive overtime or bonuses not expected to recur.

Adjustment abusers bias toward overstating savings. Do not use adjustments as a crutch. Self-delusion does no good. It rationalizes goals beyond your reach. Goals may look good on paper as a result, but are unachievable in reality.

Be very careful with adjustments!

LIKELY DESTINATION
After adjustments (hopefully none), determine where your drifting boat will meet land. Four-steps are necessary:

• Step One: Assets Owned:
  • List the assets you own and their current values. Assets like a home or brokerage account are meaningful because they usually appreciate. Most other assets are irrelevant because they depreciate. (An automobile, for example, is the perfect example of a “wasting asset.” It is a high-dollar outflow which moves over time toward a zero value. For most people, it is a major drain on wealth creation). “Wasting assets” must not be a part of these calculations.
• Step Two: Determine Your Terminal Date
  • This ominous heading refers to the date you want to know your wealth, not a prediction of when you leave the planet. It is a terminal wealth date. The date is your choice. Typically, it reflects an expected retirement date.
• Step Three: Estimate Your Savings
  • Use the results of your cash flow analysis from section 4.2.1 from above. Create an additional column in your spreadsheet entitled TOTAL and then add each of the prior columns (2 or 3 columns) together to create your TOTAL column. Now create an AVERAGE column, which is the average of each of the numbers from the Total column.
  • Your AVERAGE column shows, by category, your annual results over this period. These results are used to determine where your drifting boat heads.
  • If average savings is negative (dis-savings) and you don’t have a home or brokerage account, you will have negative terminal wealth. Regardless, use this number (positive or negative) in your calculations. Treat the annual savings number as an annuity that repeats every year until your terminal wealth date. (Appendix I deals with compounding, including annuities for those needing help. It provides an annuity calculator.)
• Step Four: Calculate Terminal Wealth
  • You have the current value of owned assets (determined in Step 1). You have a terminal wealth date from Step 2. You have annual savings (or dis-savings) from Step 3. All dollars are in current time periods. All need to be converted into a future value amount (as of your terminal wealth date).

GENERAL ASSUMPTIONS
Assumptions regarding growth rates are necessary. The following summarizes the assumptions used in most of the calculations in this book:

• An owned residence grows in value at 3% per year (at the time of writing, housing prices are exploding, likely making some think this rate too low).
• Stock market funds grow at 10% per annum. This rate applies to all savings unless specified otherwise. (Given the ebb and flow of financial markets, some may consider this rate too high or too low.) You may use whatever rate you consider appropriate.
• Collectibles like diamonds, paintings, etc. usually appreciate. Consult an expert for a realistic rate of growth (or estimate one yourself).
• Use different rates of appreciation if you wish, but be aware that minor changes in interest rates over long-time periods produce substantially different terminal values.
• Appendix I: Time Value of Money provides the basic concepts of discounting and compounding.

EXAMPLE PROBLEMS AND SOLUTIONS

This section provides two problems (and solutions) pertaining to terminal wealth. Both use models from the web.

Problem 1:

• You are 40 years old and plan to retire at age 60.
• You rent your home and will continue to do so.
• An IRA worth $20,000 is available.
• Your plan is to add $1,000 of savings to that IRA each year until age 60.

What will your net worth (wealth) then?

Solution 1

I solved this problem with the help of Calculator.net and their financial calculator. (They offer a variety of free calculators, as do others referenced in Appendix I). The proper inputs appear in the model below:

image

The above table shows wealth by year in the FV column. (Ignore the negative signs in this column.)

You just calculated “landfall” for someone’s hypothetical plan!

Congratulations, especially if this is your first future value calculation.

Let’s look at another example:

Problem 2:

• You deem the $197,500, just calculated, insufficient for your retirement and want to know what this number would be if you continued to work for an additional ten years (until age 70).
• You plan to continue your savings during this period.

What would your terminal wealth be under these circumstances?

Solution 2

• This calculation uses the same model as above. The proper inputs and
  answer are below:

image

Your terminal wealth would now be $527K. Wow! That sounds a lot better!

Most of the improvement comes from allowing the money accumulated by age 60 to compound forward another 10 years. How much would that be? That answer is for you to determine. Go ahead, you should be able to figure it out.

If this were a real-life situation and you were happy with the numbers above, you might consider not saving the additional $1,000 per year after age 60 to enhance your lifestyle during that period (better vacations or what-not). Again, you are on your own to calculate how that would change your terminal value at age 70. Reviewing and understanding these trade-offs enables you to make rational retirement decisions.

If you still need help with the mechanics of annuity calculations, consult Appendix I.

Now it is time to personalize these calculations for your situation.

DO YOU NEED A BETTER DESTINATION?
If you went through similar calculations, using your own numbers, you know where your drifting boat is taking you.

DRIFTING NICELY
If satisfied with the destination, congratulations! It is a sign that your boat was not truly unmanned or unplanned. Something or somebody likely got you started on the right course. If satisfied, stay on course!

Even if you are happy with your terminal wealth estimate, experiment to see how higher or lower savings changes estimated terminal wealth. Doing so allows you to determine tradeoffs between spending more now or saving more in terms of terminal wealth. Knowing these effects will allow more rational choices between current and future pleasures.

DRIFTING UN-NICELY
The results will disappoint most readers. Sadly, many will fall into one of these outcomes: You will have some wealth, but nothing close to what you need. BAD. Someone will have to feed you. TERRIBLE!!

Do not count on government feeding you in the next 20 years. It is likely to be in worse shape than you. Explanations provided in Part 2 of this book explain why.

If you fall into either condition, it is time to take control of your financial life. You don’t want to become a modern-day version of Blanche DuBois, dependent on the “kindness of strangers.”

Correcting the direction of your boat should begin as soon as possible. Time can be a precious ally or a formidable foe. Burning money is a bad thing, burning time and money is disastrous!

The above post is a slightly edited (…) version of Chapter 4 from a book entitled Wealth If You Want It by “Monty Pelerin” (a pseudonym) of EconomicNoise.com.

Pelerin has a doctorate degree in Finance from Syracuse University, an MBA from the University of Chicago and an undergraduate degree in economics from Duke University. He can be reached at montypelerin@gmail.com if you have any questions (put HELP in the subject line to attract my attention). Permission is granted to copy this post for non-commercial purposes with proper attribution.

Additional Contents of WEALTH IF YOU WANT IT

1. “Wealth If You Want It” & How To Get It: An Introduction