Retirement, financial independence, work-optional—whatever you call it—we all are working toward some version of the same goal. How do we measure progress? How much wealth does one need to be financially independent?
It’s no wonder the most common questions I hear from clients are, “Am I on track?” and “Will I be okay?”
A Better Way
At Stewardship Financial, we’ve recently invested in a new way for our clients to answer the question, “Am I on track?”
The Elements® Financial Planning System is a set of financial indicators that give you an overall view of your financial health. In addition to measuring key areas, this system helps us track your progress toward making work optional.
There are twelve financial indicators called Elements, tracked in this system. The foundational Element called Total Term, is a measure of your progression toward financial independence.
How the Total Term score works
The Total Term score estimates how many years you can live off your current assets if those assets did not continue growing. The calculation for Total Term is as follows:
Total Net Worth ÷ Annual Spending
The resulting number (your Total Term score) is the number of years your net worth can support your current lifestyle if you did not work.
How to find your Total Term score
Add up the value of your bank accounts, investments, equity in real estate, and equity in your business, if applicable. If you have student loans or other loans not collateralized by your home or business, you’ll want to subtract these balances to make this a true “net worth” number.
The second step is to estimate your annual spending. This is an “all-in” number including essentials, discretionary expenses, and debt payments, but doesn’t include amounts you are putting into savings and investments. Be honest with yourself—underestimating this number will give you an unrealistic Total Term score.
Let’s look at an example Total Term score:
Bank accounts: $50,000
Retirement accounts: $475,000
Real estate equity: $250,000
Total net worth = $775,000
Annual spending = $90,000
Total Term = $775,000 ÷ $90,000 = 8.6
In this scenario, this person has accumulated enough to live off his assets for 8.6 years.
Why is this a better approach?
Often, traditional measures of progress toward making work optional are confusing, involve too many variables, and are easily manipulated. You’ll need to input assumptions for future rates of return and inflation, with small adjustments resulting in outsized differences.
Why have I started using this approach?
- It’s easier to understand.
I don’t want to confuse my clients. Relying on sophisticated tools looks good, but it doesn’t always give people what they want—a simple way to measure financial independence.
Anyone can run this calculation if they know their net worth and spending. It doesn’t rely on capital market assumptions or complex “what if” scenarios.
- It brings spending into focus.
Total Term is a ratio of net worth to annual spending. Most people are fixated on the numerator (net worth). But play around with the numbers and you will find the denominator (annual spending) is equally, if not more, responsible for retirement readiness.
Best of all, it can be easily measured and tracked over time.
What Total Term score is needed to truly make work optional?
For someone retiring at a “normal” age (60-65 years old), most would want to see a Total Term score in the range of 25 to 30. Put into practice, this would comfortably allow your assets to sustain your lifestyle through age 85 to 95.
If you are trying to achieve financial independence earlier, a higher score would be needed to account for a much longer time horizon without employment income.
But what about my primary residence?
Be careful— a Total Term score of 25 by itself doesn’t mean you can quit your job. It’s important to look at each component of Total Term to analyze the balance of your assets.
Remember, Total Term is a total of four elements: liquid assets, money in retirement accounts, equity in real estate, and any business equity that you own.
It’s common for people to have a lot of their net worth tied up in their primary residence. So, does it make sense to include your house in your Total Term calculation? If you want to exclude it, you can. This is a more conservative approach as it only considers investable assets. But including real estate is helpful for two reasons:
- Many need a plan for using their home equity in retirement.
- You can evaluate whether your asset mix is optimal.
For example, what if 12 of your 25 Total Term scores are in your primary residence? With this asset mix, you likely cannot stop working without using your home’s equity. This is because you only have 13 years of expenses saved up in investments. Planning for a 20 to 30 year retirement isn’t possible without considering your home equity.
Additionally, people with several years before retirement can use this framework to evaluate how their asset mix is progressing. If you are putting most of your excess income into paying down your mortgage, you can use these scores as a guide for ways to optimize your balance sheet.
Putting it all together
How much wealth do you need to make work optional? Using the Elements® Financial Planning framework, dividing your Total Net Worth by your Annual Spending will give you an estimate of the number of years you can live off your current assets.
Anyone can run this calculation; it places equal emphasis on net worth and spending, and your progress can be tracked.
Most people should aim for a Total Term score of 25 or more, depending on the desired age of making work optional.
In addition, your asset mix is important. Placing too much of your Total Term in your primary residence or vacation property requires honest conversations about what to do with that much home equity.
As financial advisors that use Elements, we can now give our clients the tools to track their net worth and Total Term and to place milestones around their progress. Along with answering their question, “Am I on track?” we also compare our client’s progress with where they should be relative to their age and income level.
If you want to get specific about your long-term strategies, request an appointment with one of our financial advisors.