01 November 2007
Like a long drive through the country to grandmas on a fall day, we should all be asking ourselves, “Are we there yet?” When clients walk in the door, they typically are thinking about major milestones in their life like retirement, or college for their children. Yet there are many mile markers along the route that should be observed if the ultimate destination will be as pleasant as our dreams would make us think.
Charles Farrell, J.D. LL.M., a financial planner in Ohio, has developed the notion of personal financial ratios, similar to the stock market. Just like one might look at a stock’s price to earnings (P/E), price to book (P/B) and dividend yield for a companies financial health, Farrell has developed savings to earnings (S/E), debt to earnings (D/E) and savings rate to earnings (SR/E) ratios to help understand our personal financial health.
I will not go into great detail on each of these, but it is interesting to look at one ratio just to see how it impacts all of us at different ages. Suppose one had a $70,000 income and investments (including 401(k)) of $160,000. The S/E would be 2.29 ($160,000/$70,000). Without going into all of the assumptions that Farrell makes, he devised a table to look at what this number should be at different ages. For a 35 year old, he decided that the S/E should be .9; at 45, 3.0; at 55, 6.5; and at 65, 12.0. Thus, in my example, the 35 year old has saved more money than most in their age group, but at later ages, would be in trouble for retirement.
If I delved into the D/E ratio it would show that early on in life, one’s debt could run as high as twice their income, but by the time one retires, they should have no debt. This may seem obvious but what is surprising is that most people we talk to have debt levels that are four or five times their income and they still carry a huge mortgage at retirement.
Finally, a careful examination of the SR/E ratio would show that one needs to save a minimum of 12% of income per year, possibly higher than 20% for some who want a more comfortable retirement. Again, we rarely see this happening day in and day out.
What we learn by simple, entertaining statistics should lead us all to drastic behavior modifications. Obviously the ratios mentioned are ballparks and everyone has a different scenario. But they do allow one to ask, without getting to the final destination and finding we forgot to pack our luggage, are we there yet?