Introduction: Your Net Worth

Your wealth is defined by your net worth, not just your income. Your net worth is the amount by which your assets exceed your liabilities. Your assets include your home and real estate, cars, boats and other vehicles, personal items, stock and investments, cash, and other valuables that you own. Your liabilities include your mortgage, home equity loans, car loans, credit card debt, education and other loans, and any other debt that you may owe.

Financial planning, budgeting, saving, and investing are key to building your net worth. If you are fortunate to receive a large salary but you save nothing, then you have not grown your net worth. Most people consider planning and budgeting to be boring activities.

We tend to procrastinate. Don’t wait for an emergency! Similarly, we aren’t inclined to delay gratification. Purchases made today are more tangible than future purchases even if the time value of money (i.e. the purchase price) has greater utility in the future due to compounding.

Start Saving Early in Life and Automatically

Americans do not save enough for their retirement. In 1960, the personal savings rate–the portion of personal income that is used either to provide funds to capital markets or to invest in real estate–was nearly 11%. By 2008, it fell to only 2.2% Since then, the personal savings rate has risen to approximately 6.5%.1

As of 2017, the median U.S. household earns $61,372.2 Assuming that you need 80% of your pre-retirement income to maintain your standard of living and applying the 4% rule, the median U.S. household needs at least $1.27 million in savings. As of 2016, the median net worth of all U.S. families is $97,300. For families with a head of household between 65-74 years old, their median net worth is $224,100.3 Less than 10% of the U.S. population has $1.27 million or more in net worth.4 Regardless of what you have saved to date and even if you have suffered significant financial losses due to loss of your job or business or unanticipated medical expenses, there is still the opportunity to rebuild your wealth.

Assuming that you save from ages 25 to 67, then you should save a minimum of 15% of your pre-tax income. Ideally, you should save 20% of your pre-tax income.5 If you save fifteen percent monthly, that is the equivalent of dedicating 1.8 months of your annual salary to your savings. Likewise, if you save twenty percent monthly, then you are dedicating almost two-and-a-half months of your annual salary to your savings. If you start saving later or wish to retire earlier than age 67, then you will need to save a higher percentage each year.

You will need to enter retirement with a minimum net worth of at least 25x your last year’s salary to maintain a comparable standard of living in retirement.6 That calculation assumes that you have no mortgage and no debt when you retire. Fidelity has a useful calculator here.7

Prioritizing How You Save and Spend

Below is a general recommendation on how to prioritize where you save and/or spend your income based on the expected risk and return. The first two–employer matched retirement contributions and paying off high interest debt–apply universally. Beyond that, your financial circumstances, your employer’s flexible benefits plan, and your tax bracket will inform how and through what investment vehicle you should save.

1. Max out Your Defined Contribution Retirement Plan Up to Your Employer’s Match

No matter how bad your credit cards’ and loans’ interest rates are, you are likely better off contributing first to your company’s defined contribution plan up to the limit of your employer match. Many companies offer a 401(k) retirement plan. Nonprofits may offer a similar plan, 403(b). When your employer matches your investment, you receive an immediate, risk-free 100% gain on your investment.

Further, contributions to these plans are tax deferred. Because you do not pay taxes until your withdrawal, you save more due to compounding. In taxable accounts, you must pay capital gains taxes each year. For this reason, unless you have high-interest debt, you should maximize your contribution to your tax-deferred account (beyond your employer’s match). Unfortunately, “only 35 percent of Millennials have a company 401(k) or other retirement account, and just 14 percent feel they are on track to meet their retirement goals”.8

Your retirement plan manager (likely determined by your employer) selects the funds in your retirement plan. Bear in mind that some funds may be actively managed and/or relatively high cost. You should always invest in low cost, total market index funds within your retirement plan.

2. Pay off Your High-Interest Debt

Next, you should pay off your high-interest rate loans such as credit card debt. Beyond credit cards, you should avoid payday loans, subprime auto loans, tax refund loans, and similar high-interest financing. It is far too easy to borrow beyond your means. As of 2018, the average credit card interest rate is over 17%.9 Over 40% of credit card users carry balances from month to month.10 As of 2014, the average American holds a mean of 3.7 credit cards.11 And, the average credit card balance is $6,354.1213

Never carry credit card or other high interest debt month to month. Credit cards are for convenience. They can be valuable both due to float and as a means of building and maintaining your credit score. Take advantage of their interest-free grace period. Use a credit card, rather than cash, so you can easily record all your transactions. Shop around for the best interest rate and the lowest fees.

But, never pay for anything on a credit card that you couldn’t immediately pay for in cash. If you cannot control your credit card spending, then you should use cash or a debit card instead. If you have outstanding credit card debt, consider shifting it to a lower interest rate loan, such as a home equity line of credit.

Paying off your high-interest debt is one of the highest return and lowest risk investments that you can make. There is no point in trying to figure out how to maximize return for a given level of risk if you are in debt beyond low interest, long-term home mortgage and car loans. The reason for this is that you likely will spend more on interest for your loans and credit card debt than you ever would recoup by investing an equivalent amount minus fees, taxes, and your high-interest debt. Moreover, your debt servicing costs are known while your potential investment returns are unknown, only expected.

If you question whether your loan is ‘high-interest’, then compare your debt servicing costs to the expected return if you invested that cash in the market based on your target asset allocation. For example, if you can secure a 0.9% APR rate for a car loan, then you are likely better off taking out a car loan than paying for the car in cash. You can then use the cash that you would have used to pay for the car to instead invest in your savings. Similarly, if your home or educational loan rates are less than 4% nominal14 APR, then you are are likely better off investing your savings in the market rather than paying down your home or educational loans. Conversely, if your loans (car, student or otherwise) are higher than 4% nominal APR, then you should consider paying them off before investing those sums in the market.

3. Create an Emergency Fund and Credit Line

Now, you should create an emergency fund and establish an emergency credit line. According to the Federal Reserve, “Four in 10 adults in 2017 would either borrow, sell, something, or not be able pay if faced with a $400 emergency expense.”15 That is why you should ensure that you have at least six months of emergency funds in accounts that won’t penalize you for withdrawing funds. You never know when you might find yourself unemployed, facing unexpected medical expenses, car repairs, or another emergency that requires immediate access to funds. Your cash reserve can be a checking, savings, or a money market account held at your bank or credit union.

Additionally, I recommend securing a line of credit when you don’t need it. If you are a homeowner, a home equity line of credit is a relatively low interest reserve that you can draw upon in case of an emergency. This line of credit can serve as a short-term bridge if you should need to liquidate other assets during that emergency.

4. More Tax Advantaged Savings

Having maxed your employer-matched, tax-deferred contribution in step one, now you should max out your tax-deferred and other tax-advantaged retirement contributions.

5. More Investing

Finally, even if there are no tax advantages, you should continue to save until you have hit your savings threshold (i.e. 15-20% or another, higher percentage required to catch up to your retirement objectives). After all, you are investing in your future happiness. It is far better to have saved too much, than to have saved too little for your retirement.

Budgeting

1. Track Your Spending Throughout the Year

Saving begins with an awareness of your income and expenses. If you don’t monitor your inflows and outflows, you are not alone. Most households do not keep even a simple budget.16 Budgeting forces you to determine how much you will save and how you will allocate your average monthly income to your average monthly expenses. Of course, not all income is received or expenses incurred monthly. Budgeting should prevent you from overspending. I recommend using a software application like Quicken or a financial website like Intuit’s Mint.com17 to automatically generate a twelve month report from your past income and expenses.

Examining all of your spending across a year enables you to see both large and small outlays, scheduled and otherwise. Some expenses are sporadic, such as unscheduled visits to your doctor, dentist or veterinarian, unexpected home repairs, and unanticipated car repairs.

2. Create a Budget (Prioritize Your Spending)

From this report you should identify three categories:

1. necessary spending
2. “small luxury” splurges
3. excess spending

Then, you will be able to assess trade-offs in your spending. It is important to be both realistic and flexible so that you stick to your budget.

Your rent or mortgage, transportation, health insurance, and child care costs are unavoidable and, likely, your largest outlays. Therefore, in the long term, it is essential that you control these costs. But, in the short term, you likely won’t be able either to defer or to rapidly reduce these costs without incurring additional charges.

Beyond the essentials, don’t deny yourself some “small luxury” splurges such as dinner out, a concert, or tickets to the movies. If you cannot enjoy these splurges, then you are more likely to bust your budget.

Finally, pay attention to excess spending including impulse purchases.

3. Achieve Your Plan

The easiest way to save is to have the monies automatically deducted from your paycheck, particularly if they can be directed to a tax-advantaged investment account. This will reduce the temptation to spend those monies today. Investment professionals frequently describe this as “paying yourself first.”

4. Maintaining Your Fiscal Health

• Always think in terms of your opportunity cost: for every dollar that you spend today, consider what it could otherwise grow into. There is an inverse correlation between saving and spending. The more that you spend today, the less money that is available to spend tomorrow. The earlier that you start saving and the more that you save, the greater your wealth will be due to compounding. If you must use debt, then make investments in things that gain value such as an education or your home.
• Live within your means. Don’t feel like you need to keep up with your ‘peers’. Avoid conspicuous consumption such as impulse purchases and lifestyle creep. Think twice about whether you need to wear the latest clothing fashions, to purchase the top-of-the line smartphone, to drive a sporty new car, or to go on an expensive vacation. Even small things–like dinners or drinks out with your friends, your morning coffee, unnecessary electricity consumption, low deductible  health and car insurance plans, health club memberships, and your cable bill–all add up over time.1819The Social Security Dilemma20
• Steward your credit score. Monitor it monthly. Regularly request your credit reports from the three bureaus (Equifax, Experian, and Transunion) to ensure there are no inaccuracies. Always pay your bills on time. Only use the credit that you need. The higher your credit rating, the lower the cost of your debt financing, when and if it makes economic sense.

Defer Retirement

There is no rule that you must retire at 60 or 65. Most people associate ages 60-65 with retirement because that is when Social Security benefits commence. In 1935, when Social Security was created, the average life expectancy was only 61 years.21 According to the National Center for Health Statistics, in 2016, the life expectancy at birth for the total U.S. population was 78.6 years. For men, their life expectancy was 76.1 years. Women could expect to live five years longer than men: 81.1 years.22

For retirement planning purposes, a better measure is your life expectancy having reached the age of 65. That is when most people will cease to earn income and, instead, start drawing down their retirement). For both sexes, life expectancy was 19.4 more years. Males had a life expectancy of 18 more years. Females had a life expectancy of 20.6 more years.23 In other words, their savings needs to cover them for 18-21 years, on average.

You can–and, depending on your finances, should–chose to continue working full-time until you are 70. Even after you retire, you can chose to work part time. As of 2012, 26% of the population ages 65 to 74 are part of the civilian labor force. By 2022, that percentage is expected to increase to 32%.24

Summary

Coming soon!

For More on this Topic

“Report on the Economic Well-Being of U.S. Households in 2017” Federal Reserve. May 2018.

Updated on January 5th, 2019