Calculating your expected net worth

I did not define "expected net worth" in my previous post because I think it is an imprecise exercise. You need to make many assumptions on many variables to calculate your "expected net worth" that will last you through retirement. I know of four published formulas for calculating "expected net worth". Two formulas were published by Thomas J. Stanley andWillaim D. Danko, and two methods were published by Marotta Asset Management.

Thomas J. Stanley's and William D. Danko's expected net worth formulas

  • Formula 1: Expected net worth = age x 0.1 x gross income.
  • Formula 2: Expected net worth = age x 0.112 x gross income.
Formula 1 is from The Millionaire Next Door and formula 2 is from The Millionaire Mind. Stanley & Danko say that the average person should accumulate between 50% to 200% of their expected net worth, they call them Average Accumulators of Wealth (AAW). Those who accumulate less than 50% of the expected net worth are Under Accumulators of Wealth (UAW). Those who accumulate more than 200% of the expected net worth are considered prodigious accumulators of wealth (PAW).

These methods will calculate "expected net worth" that is unrealistically high for young people who just started work, and too low for people near retirement. Twenty-four years old college graduates who have worked for only 2 years are expected to have a net worth 2.4 times their gross income, an amount impossible to achieve. Sixty-five years old workers heading for retirement are only expected to have a net worth 7.28 times their gross annual income, an amount that probably won't last as long as they will live (especially with the lengthening life expectancy).

Marotta Asset Management's expected net worth formulas
  • Formula 3: Expected net worth = (adult years / 240 + 0.1) x adult years x gross income; where "adult years" = age - 20.
  • Formula 4: Expected net worth = [(age / 166) - 0.15] x age x gross income.
These formulas closely reflect the reality of saving and investing for retirement. Formula 3 will be zero for anyone aged 20 or below, and formula 4 will be negative for anyone aged 24 or below. Those who are young will probably have just started working, getting married, having children, and paying off their student loans and mortgages, and thus cannot save much and have very little net worth. Those who are older probably have paid off their mortgage and their children are now working adults, thus they can accumulate wealth more quickly by saving and investing more of their income.

Note: These formulas assume a retirement age of 72, and for every 0.5 times gross income you are over the expected net worth, you can retire one year earlier.

These formulas, however, are still "black boxes". I'd like to know why we should have what amount of net worth by what age, what assumptions are made, and whether it will last us through retirement.

My expected net worth spreadsheet
My way of calculating expected net worth is more complicated. I first determine the expected "productive assets", then add "non-productive assets" to find total assets. Since liabilities will reduce net worth, I offset their effect by adding total liabilities to total assets to find the expected net worth.

Productive assets are investment assets that will produce income and earn a return while you hold them, such as bonds, stocks, real estates, etc. On the other hand, non-productive assets, such as your home and cars, do not produce income and may even consume money. So, in my spreadsheet calculations, I calculate investment returns based on the productive assets accumulated.

The spreadsheet calculates the percentage of gross income saved every year, then compound the assets accumulated until retirement. Upon retirement, I calculate the expected living expenses (adjusted for inflation), life expectancy, and funeral costs, to determine if the money will last until my funeral. For example, if I earn $1,000 per year and allocate 20% to my retirement fund, assuming 3% income growth, 3% inflation, and 6% investment returns, I can retire at 67 and the money will last until my death at 90.

Download my spreadsheet and play around with it - try and see how much you need to last you through till retirement and death. Here are a list of variables and assumptions you can change:
  • Year of birth: Used to calculate your age.
  • Year first worked: Used to determine the starting point of your financial journey. You can change it to the current year to see how much you need to save from now onwards in order to have enough for retirement.
  • Gross income: Your total gross income, including employment and business income.
  • Productive assets: Your total productive assets at the starting point.
  • Savings rate: The percentage of gross income you save for retirement. All the savings are assumed as allocated towards investing in productive assets.
  • Income growth rate: The rate that your gross income is expected to grow. My default of 3% simply assume your income will grow in-line with inflation.
  • Rate of return: The rate of return on your total productive assets. I use a conservative return rate of 6% as my default assumption. I expect a balanced mix of bonds, stocks, and real estate to return less than an all stock portfolio.
  • Inflation rate: The expected rate of inflation. The calculation of your retirement living expenses and funeral expenses are adjusted based on this rate.
  • Living expense: The living expense you expect to use in your retirement (at present value).
  • Retirement age: The age you expect to retire.
  • Pension: If you expect to receive a pension, enter it here (at present value).
  • Pension growth: If you expect your pension to increase over time, enter the expected growth rate here (for example, if it's adjusted for inflation).
  • Life expectancy: How old are you expected to live until? I am conservative and use 90 when 80-85 is the average life expectancy. I just want to make sure I don't run out of money if I live longer than average.
  • Funeral cost: The cost of funeral at present value. I want to have enough so that no one else will have to bear the burden.
In the spreadsheet, there is also a table showing the expected net worth (in terms of multiples of your gross salary) at various ages. My calculations of expected net worth comes close to Marotta Asset Management's formulas, so if you want a set formula, I recommend using their formulas (use whichever one that produces the higher value).

How are you performing and what should you do?
If your net worth is far below the expected net worth, you can catch up by being thrifty, minimizing expenses and maximizing contribution to your retirement fund. I recommend reading my series on the principles of wealth accumulation.

If your net worth is the approximately equal to the expected net worth, keep up the good work!

If your net worth far exceeds the expected net worth, congratulations, you may be able to afford an early retirement! When you know you are wealthier than expected (or wealthier than average), however, it is easy to fall into the trap of "lifestyle inflation" - the growth of living expenses to pay for a more lavish lifestyle. Guard against lifestyle inflation, and you should be on track for a comfortable retirement.

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P.S. This post was featured in the 149th Carnival of Personal Finance - Chasing Dreams Edition at The Happy Rock.

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