One of the most common questions from prospective clients can be boiled down to this: how are we doing? In our culture, our finances are often kept secret even from extended family. We don’t have anyone to talk to about our financial strength (or weakness) besides our spouse and that’s only if you’re married.
Sure there are online calculators that can be used to gauge your fiscal fitness, but most of us need something beyond that for clarity. We need to know whether we’re ahead of schedule, or need to scramble, scrimp, and save to meet our goals.
One tool we use is the Financial Life Cycle, which is the brainchild of fellow financial planner Bert Whitehead, founder of the Alliance of Comprehensive Planners and author of Why Smart Do Stupid Things with Money updated in 2013.
The Financial Life Cycle only needs three or four data points to render its verdict on your finances. First, we need to understand your net worth, which is the value of your investments, cash, and real estate less any debt that you have. Have your investments (including equity on real estate investments) broken out separately as we’ll need that precise figure later. Second, we need your annual salary.
Finally, look at your level of spending for a year, including some “bumpy” expenses such as home maintenance and car payments. Don’t worry about the exact budget categories at this point. Instead consider your annual take home pay, and how you build up or drain down savings throughout the year. If you’re running a credit card balance, consider changes in that balance as well.
Getting Started. This is the first adult Life Cycle, and is defined as your net worth being less than your annual salary. You enter Getting Started when you become self supporting. In this stage, you want to focus on the fundamentals. Save 15 percent of your income, accumulate one to two months of spending in cash, pay off your consumer debt with the possible exception of a low interest car loan, consider investing in your human capital in the form of education, and get on track to own your own house. These financial fundamentals are important throughout your life, but are vital at this early stage.
Early Accumulation. You enter this stage when your net worth exceeds your annual salary. This is generally when people start to focus more on their investments because they’ve accumulated enough so they want to make smart decisions. At this stage, we educate them on the benefits of diversification and about the options for regular investing outside of their work retirement plans. It could be a Roth IRA or brokerage account at a low cost custodian such as Charles Schwab or saving for an investment property.
Rapid Accumulation. This stage begins when your net worth exceeds three times your annual salary. We say this stage is when your financial trajectory moves upwards like a hockey stick. In general, in Rapid Accumulation your investments start appreciating and earning more than you are able to save out of your salary. In other words, your money is making more money than you are able to save. At this stage we focus on tax efficient investing using the three major account types: pre-tax (such as a 401(k)), taxable, and tax-free (Roth IRA).
Financial Independence. When your investments (not net worth) are more than seven times your annual spending, you’ve entered Financial Independence. There is an important shift here, as we move from looking at your net worth and salary, toward a focus on investments and annual spending. The idea is that we consider your investments in the context of supporting your living expenses by using your investment earnings. In this stage, you review whether your current career and role are enjoyable as with this level of financial strength you may have the flexibility to consider other opportunities that don’t pay as well. This can also be a good time to start a business.
Conservation. Once your combined investment value has passed ten times annual expenses, you have reached Conservation. Depending on your age, this could mean that you are financially strong enough to stop working all together. If you reach Conservation at age 68, you’re close to receiving maximum Social Security benefits, and generally eligible for Medicare health insurance. When our clients in their 30s and 40s reach this stage, we congratulate them but caution reading too much into this stage. After all, their money must last much longer than the typical retiree!
Distribution. If your investment balance exceeds 15 times annual expenses, you’re in the Distribution stage. If you’re close to normal retirement age, this stage tells us that it’s very unlikely that you will run out of money in your lifetime unless you acquire bad habits or make destructive financial decisions. At this point you’ve won the financial game, and care should be taken to design your portfolio and cash flow to insulate you in the near term from the ups and downs in the market. While you may worry about geopolitical trends and domestic politics, smartly invested you will be in good shape. The caveat about young age also applies here: if you’re in your 40s and still have kids to put through college, you may not be ready to quit tomorrow!
With any model of financial health there are bound to be exceptions. Younger people have a harder time retiring than those in their 80s. College and long-term care costs can come into play. Your annual expenses may be significantly below your salary, which can understate your financial strength. But it’s a fun and helpful gauge to see how you’re doing, and also a good reminder that your financial strength depends much upon how much you spend.
We like clients to progress through at least one Life Cycle stage per decade, with two jumps within reach for ubersavers. Chart your progress over time. You may think you’re not making progress because cash is tight every month, but when you consider the whole picture you’re making tremendous progress.