Is your money in balance? Figure out your money ratios.
Every Sunday, The Simple Dollar reviews a personal finance book or other book of related interest.
One thing I often do when looking for books to read and review for The Simple Dollar is simply go to the 鈥渘ew releases鈥� section of my local library and browse the personal finance new releases. That is exactly how I stumbled upon by Charles Farrell.
My usual method of deciding whether to review a book is to simply study the dust jacket for a moment, seeing if there鈥檚 anything there that gives me an indication I should stay away (like talk about 鈥渇inancial apocalypse鈥� or something else wholly fear based). I usually then open the book to several random places and see if I find anything interesting, and if I鈥檓 still unsure, I鈥檒l take the book to a chair and read the first chapter or so.
I popped this book open to the start of the first chapter and was immediately intrigued. Let鈥檚 see what exactly Farrell has to say in this book.
1 | The Capital to Income Ratio
Farrell opens the book by arguing that, by the time you retire, you need to accumulate 12 times your annual salary, which will put you in the position to live on about 80% of your annual income. The 鈥�12 times鈥� number comes about from an assumption that your money will return, on average, 8% a year. Thus, if you feel like that return is too optimistic, you should have a higher 鈥渢imes鈥� number.
Let鈥檚 say you make $50,000 a year 鈥� not in take home, but in total income before taxes. Farrell argues that you need to have $600,000 saved for retirement. Then, each year, you would withdraw $40,000 (80% of your salary) of that $600,000 and leave the rest invested. In order to maintain the same balance of $600,000, your investment would have to earn 7.15% 鈥� and, ideally, it would earn a little bit more than that to help you keep pace with inflation.
2 | The Savings Ratio
In order to achieve that goal, you need to be saving some portion of your income. In some form or another, Farrell argues that you need to be saving 12% of your income (if you鈥檙e 45 or under) or 15% of your income (if you鈥檙e over 45). This means savings that you鈥檙e retaining, not savings that you鈥檙e simply spending in a year or two. The most common place people put this is in their retirement savings.
3 | Social Security
Farrell makes an impassioned argument about the long-term stability of Social Security and argues that it will make up around 20% of the average American鈥檚 retirement income. I tend to plan for retirement assuming nothing from Social Security, as I intend to look at any Social Security checks I receive as icing on the cake.
4 | Where to Save Your Money
As you sock away money to meet that 鈥渢welve times鈥� goal from the first chapter, your priority should first be to your 401(k), then to your IRA, then to other investing options. I think that鈥檚 reasonable, though I think there are some fair arguments one could have about a Roth IRA versus a 401(k). You need this savings to be automatic, so set up automatic deductions from your paycheck or automatic transfers out of your checking account to cover this savings.
5 | The Debt Ratios
This chapter looks at the simple question of whether debt can help you to move from being a laborer to a capitalist. In a narrow sense, yes, it can, as debt can reduce the monthly cost of your housing and other needs in the short term. However, if you don鈥檛 pay off that debt at a reasonable rate 鈥� or if you acquire high-interest consumer debt 鈥� your debt will hold you down. His big point is that borrowing for a mortgage is pretty much the only significant debt an adult should acquire and that it should at most be two times one鈥檚 household income.
6 | The Investment Ratio
If you鈥檙e under sixty, Farrell recommends having half of your investment in stocks and the other half in bonds. If you鈥檙e over sixty, it should move more towards bonds. This is a pretty conservative investment stance, one that would be a bit of a stretch to get the 7% return that Farrell claims you will need in the first chapter. I think it鈥檚 reasonable, though, to park your money in a target retirement fund, as these will provide the same 鈥渕ore conservative as you age鈥� effect, but add more risk and reward when you鈥檙e younger.
7 | Stocks and Bonds 101
Two things are needed here: rebalancing and diversification. Your stock investments should be spread across lots of different companies, including international ones, big ones, and small ones. Your bond investments should largely be in government bonds, but should be diversified there as well. For rebalancing, each year you should move money between the stocks and bonds to restore the overall 50-50 balance described earlier.
8 | Ignoring Wall Street
Don鈥檛 spend your time worrying about what Wall Street is saying. They鈥檙e often worried about the short term 鈥� the next few years 鈥� while you鈥檙e not really that concerned about it at all. You鈥檙e worried about the long term, something rarely discussed on CNBC. Don鈥檛 let it worry you.
9 | The Disability Insurance Ratio
Farrell recommends getting coverage equal to 60% of your income, which will roughly amount to your current income after taxes. This payoff will largely replace your current take-home, which means your current standard of living won鈥檛 be significantly altered by a disability.
10 | The Life Insurance Ratio
Your life insurance should be a term policy that pays out 12 times your salary minus your capital-to-income ratio (discussed earlier). So, for example, if you make $70,000 a year, your total of your capital and your life insurance benefit should be $840,000 per year.
This, of course, means that as you save more, you should need less life insurance. Thus, a twenty or thirty year term policy might not have to be renewed at all once the term ends.
11 | The Long-Term Care Insurance Ratio
You should start looking into long-term care insurance in your mid-fifties, not before. Before that, the risk is so low as to not be worth the cost. After that, your risk goes up enough that the cost might be prohibitive. This chapter is easily the most complicated in the book, but it also has a fairly small target audience (people in their fifties).
12 | Health Insurance
Farrell鈥檚 argument here is that health insurance is going through major reform and thus the best thing you can do to insure yourself the lowest cost on health insurance is to simply focus on yourself. Keep fit. Eat well. Doing these things will keep your health insurance costs lower and extend your healthy lifespan.
13 | Getting Professional Help
If all of this is too complicated, Farrell advises seeking a professional financial advisor. The factors you should look for are competence and training, ethics, and independence. Beyond that, I recommend seeking a fee-based advisor who doesn鈥檛 have a financial stake in pushing you towards certain investments. Farrell offers a few warning signs of a bad advisor, particularly one who promises over-the-top returns or anything like that.
Is Worth Reading?
succeeds in setting up a handful of numerical 鈥渞ules鈥� for people to simply follow 鈥� and if they follow them, they will find themselves in a reasonably good financial spot. In places, the book does a good job of explaining the 鈥渨hy鈥� behind the ratio and the numbers are largely based on good principles (though I think the predictions about future returns are a bit strong).
If you like numbers but are pretty uncertain as to exactly how to calculate what you鈥檒l need for retirement and for other purposes, is an excellent book for you to read.
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