I read this article recently, thought it was an interesting way to look at calculations (can't do a link sorry):
There are a number of different methods, that are used to measure how good or bad your financial situation is, with some being more complicated than others. The most common being what your net worth is, but even with that, it can be difficult to know if the calculation you are using is correct or not. And even if it’s reasonably accurate, what purpose does it really serve?
That’s an argument we can have another day. For the purpose of this article, I want to share with you a quick and easy to understand calculation that I like, and it’s called the rich ratio.
The simplest tools in my opinion are the best and this one is particularly useful when looking at the amount of money you will have in the future, in relation to the amount of money you’ll need. It’s very useful to get a reference point or number you can benchmark your personal situation against, and the rich ratio gives you just that.
(You can apply this ratio, by the way, to many other aspects of your financial life e.g. your monthly income and outgoings)
The term rich ratio is a bit misleading, because the ratio applies to everyone, regardless of their income levels. In fact, the amount you earn in many ways is largely irrelevant.
The ratio is calculated by dividing your income by the amount you spend.
And anything with a ratio over 1 is great, you have more than you can spend, and as a consequence you are likely to be a happy person, at least when it comes to your finances that is. And anything less than 1 means you’re spending more than you have, and understandably you’re probably unhappy with your financial situation.
Let’s assume Peter is coming close to retirement and he has built up a pension that will pay him €21,000 per year. He is entitled to the maximum state contributory pension of €12,000 and he has €2,000 from another source as well.
Peter has a total annual income of €35,000.
If, the amount Peter needs to spend each year is €30,000 then his rich ratio is 1.16 (€35,000/€30,000)
Peter is likely to be a happy retiree.
Let’s look at Paul who is financially much worse off than Peter, despite the fact he earned a much higher income during his lifetime and saved a lot more.
If Paul accumulated a pension fund of €1,500,000 during his working life which pays an annual income of €60,000. When combined with other income sources, he has a total income of €65,000, you would think he must have no worries and is blissfully happy.
And, of course that would be the case, if he spent less than €65,000 each year. But Paul likes to travel, he owns an expensive car, is a member of an expensive golf club, and has a lifestyle that costs him €80,000 each year.
This means his rich ratio is 0.81.
So, even though he had a high income and high savings, because his rich ratio is < 1, he is not rich at all, and that’s simply because his outgoings are higher than his income.
You could have saved a much lower amount over your working life than someone else, but that doesn’t mean you are worse off than them, in fact you could be much better off. If your haves (income) are greater than your needs (outgoings) it doesn’t matter how much you have saved – the key is how much you spend.
And that’s sometimes lost when people look at how much they need at retirement, they think the key to a happy retirement is measured by how much they have accumulated, and whilst it’s important, of course it is, what matters more is the amount you spend each year.
If, for example, you were able to reduce down the amount you spend in retirement by €500 each month, it means you wouldn’t have to save an additional €150,000 when you are working. Spending €500 each month, I think, is a lot easier than trying to save an extra €150,000
So, if you want a quick and easy way to figure out whether you are on track to a happy or unhappy retirement, then consider using the rich ratio as your benchmark to measure how you are doing against it.
And again, it’s simply:
Have (Income) / Need (Outgoings) = Rich Ratio.
If your ratio is > 1 then you are on track to have a happy retirement, if it’s < 1 then changes need to be made.
Because a persons’ financial situation is a factor in whether a person is happy or not, and we shouldn’t pretend otherwise because of course it does, it might just vary from person to person, the rich ratio can predict what someone’s happiness and quality of life might be like when they are older.
And you don’t have to wait to find this out or for a pension statement to tell you either, which they never do, how could they? They don’t know what your lifestyle is like or much you spend each month.
But you can discover it for yourself very quickly and easily. And your starting point is to estimate how much you need each year when you are in retirement. Use your existing outgoings as your starting point. How much would you need when the mortgage is paid off, kids off the payroll etc.
Let’s assume you arrive at €2,000 each month.
You now need to work out how much the amount you have accumulated and the amount you are saving will translate into when you reach retirement age. Let’s say you are saving €500 per month and have saved €50,000 to date and you have 30 years to retirement. Any on-line calculator will tell you that assuming a 5% annual return you will have €641,250 at retirement age, and this will pay you a monthly income after taxes of c. €1,880.
In this instance your rich ratio is 0.94, and because it’s under 1, you need to take action. You either need to reduce down your spending in retirement, or increase the amount you are saving now, or have another source of income in retirement, or continue to work – it’s your choice.
You don’t have to wait to find this out, when it’s too late to do anything about it. You can discover it for yourself very quickly and easily, and I would encourage you to figure out what your rich ratio is.
And keeping this number in mind and knowing what yours is and what side of 1 you’re on, will give you a much better chance to stay on track or make changes now that will put you above 1, and on the right path to a happier life and financial security when you’re older.