A Financial Revolution 


February 04, 2006
Using Personal Financial Ratios as a Benchmark
In last month's Journal of Financial Planning, Charles Farrell wrote about using personal financial ratio benchmarks for retirement planning. The author reasons that the benchmarks can be used to gauge whether or not you're on track to retire by 65. Alternatively, the numbers can be used to develop a retirement savings plan. The author introduces the concept this way:
Just as stock ratios are primarily based on a company's earnings, the personal financial ratios are based on an individual's income. There are three ratios: savings to income (S/I), debt to income (D/I), and savings rate to income (SR/I). Benchmarks are then created for each ratio at different ages. For example, the D/I ratio is generally much different at age 30 than it is at age 60. The objective of the ratios is to help individuals move from a situation of having high debt and low savings at the beginning of their working careers, to one where they have high savings and no debt at the end of their working careers. The ratios are designed to serve as a road map so that investors can compare their individual ratios with the benchmarks to determine whether they are on track to retire by age 65, or any other desired retirement age.

The theoretical foundation for the ratios is that there is a fundamental relationship between income, debt levels, and saving rates. One affects the other, and investors need to get their finances in proper balance...

Just as stock ratios do not tell the entire story of a company's finances, personal financial ratios have limitations as well. They are not meant to substitute for individual advice or account for all of the specific variations in people's financial lives. But they can serve as an important tool, a guideline, to help convey to individuals how their income, savings, and debt are related, and how those ratios must change over time.
The ratios begin at age 30 - the point the author believes most investors can seriously start to save for retirement - and continue through age 65.

AgeS/ID/ISR/I
300.11.712%
350.91.512%
401.71.312%
453.01.012%
504.50.812%
556.50.512%
608.80.212%
6512.00.012%

The savings or S/I ratio is calculated by dividing the current value of savings, including 401k, IRA, and brokerage accounts by annual salary. The debt or D/I ratio is calculated by dividing the current financial obligations by annual salary. The savings rate or SR/I ratio is calculating by dividing total savings, including employer matches, by annual salary. Notice that dividends and investment income are not included in income values in the formula or the savings rate. That is because the gains on investment holdings are built into the account growth assumptions that are used to calculate the benchmarks.

This approach is attractive and simple, but there are a number of caveats:
  1. Most first-time home buyers would exceed the D/I by a wide margin.
  2. The ratios assume that a retiree can live on 60% of pre-retirement income. The author assumes that Social Security will add another 20%.
  3. Investments are assumed to provide a real rate of return of 5%. Just below the historical average for a 70% stock/30% bond portfolio. However, that may be an overly aggressive allocation for a 65 to 70 year old.

The lesson of the ratios is to reduce debt and increase savings. That's good advice for everyone. These financial ratios can help you determine if you're moving in the right direction.



3 Comments:
Anonymous Lauren said...

Assuming that most investors cannot save until 30 is flawed and gives people under 30 a false sense of security. I signed up for my 401K at 21. If I had waited because someone told me I didn't seriously need to save for another 9 years, I'd have missed out big time.

2/13/2006 9:11 AM  

Anonymous Jeremy said...

Hi Lauren,

First of all, congratulations are starting to save early. I don't think, however, that the author of the article is telling people to wait until they're 30 to save. He is simply picking a point at which he believes everyone can "seriously" save for retirement. While I too started putting money into my 401(k) early, my salary (and my level of contribution) at 22 was quite low compared to where it was when I was 30. Perhaps 25 would be more appropriate.

Keep in mind that these are benchmarks. By starting sooner, you should be ahead of the game. And isn't it nice to know that you're on the path to a comfortable retirement?

2/13/2006 1:26 PM  

Anonymous Lauren said...

Oh, it's absolutely true that it's easier to save at 30 when you're making more money, but it's really important to get into the habit as soon as you enter the workforce...whether that's at 18, 21, 25, or 30+. Even though I don't think it's how he intended it, I think that it could be read by younger people that they don't need to concern themselves yet. The older and more you get used to spending your money a certain way, the harder it is to break the habit.

I do like the idea of a chart like this, though, particularly because the Automatic Millionaire definitions of overachiever and average simply do not work at all before reaching years and years of savings.

2/13/2006 5:21 PM  

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