(this is the fourth in a series of four posts)
We wrap our discussion of VIP$ - Very Important Personal Finance - Numbers this week.
These are NOT the numbers you likely have rattling around in your head. Those numbers (annual salary, size of your investment accounts, total net worth) are promoted by the personal finance industry as important gauges for THEIR success, but they are relatively useless for your ability to make great financial decisions.
Our VIP$ Numbers are specifically designed to battle your brain's wiring and human tendency to make important decisions based on bad (usually emotionally charged) information. There are ony four numbers to remember so this is a SIMPLE framework and the numbers don't change rapidly so you only need to revisit them every few months.
The first number is your Daily After Tax Income (DATI) - the amount of money you have slipping through your fingers every day. Rather than thinking in terms of annual income (which is a big number), daily spending decisions are better when compared to daily income. Your brain is more likely to see each decision as important and significant.
Last week we introduced the Future Bucket Rate - the percentage of your after tax income that is going towards future expenses - whether those be retirement, saving for college or just saving for your vacation later this year. If you always have expenses that are greater than or equal to your income, you will never build wealth.
The more money going into the Future Bucket, the more wealth you are creating.
YOUR WP - WEALTH POTENTIAL
The last of the four numbers is also (like the Future Bucket) more related to your future than your current state. Half of our VIP$ Numbers are based on the future because it keeps the whole process centered on positives. The biggest challenge for all cash flow management systems is the tendency to be focused on limitations, sacrifice, pain and self-discipline - all concepts that lead to poor financial decisions.
Your Wealth Potential is just like it sounds - the amount of wealth you have the ability to store up over your lifetime given your current income and expenses as a starting point.
This number can be pretty large. How much larger it is compared to your current Net Worth is more a function of time than anything, but even if you are going to retire in just 5-7 years, your WP can be a huge positive driver towards better financial decisions and the resulting Quality of Life improvements.
We do make a few, sometimes optimistic assumptions in calculating this number ...
--- We assume that your income will grow at a rate that is 1% faster than inflation. Over the past several decades, that rate of improvement is actually faster (as we have enjoyed accelerated productivity in the U.S.) but since the Great Recession, we have fallen short of this number. By most standards, 1% productivity improvement is considered a conservative assumption.
--- The other major (and optimistic) assumption is that you will successfully improve your FBR (Future Bucket Rate) by 3% per year until your FBR is 25%. We do adjust for the fact that some of your Future Bucket will get spent for things like vacations, college educations, etc. (our experience is that 3% of additional savings each year is quite possible - the historical average with clients is closer to 4%).
--- We assume that you will be able to collect Social Security at 60% of your inflation adjusted guaranteed rate starting at age 70 (a pretty harsh assumption but likely with the issues facing the Social Security system).
--- We assume that your investments will return inflation plus 4% and for the purposes of this number we assume that inflation will remain at the long term historical average of 2%.
Take an average, middle income family making $50,000 a year and saving nothing after taxes. They are each 35 years old. They have no assets to speak of - just living paycheck to paycheck and they want to retire at age 65 (in 30 years).
For this family, their DATI is $116.44. The Daily Control Expenses are just $29.11 (Weekly Control Expenses are $203.77) and their starting FBR is 0%. This family may think that they have very little to no Wealth Potential and if they keep living paycheck to paycheck that will certainly be the case ... but by working on their FBR they end up with a Wealth Potential of $2.1 million dollars (which they hit on the day they die at age 100).
Start with nothing and end up with $2.1 million, all by making better choices with all the money slipping through your fingers every day.
The reason we keep the Wealth Potential in the mix of numbers is that it helps to set a postive but realistic context to all the challenges presented by the current state of affairs. Living paycheck to paycheck may seem like something that will never end, and those first few years of savings will seem insignificant (less than $10,000 saved after 4 years) compared to everything else.
But even small incremental improvements over time will result in significant wealth being accumulated over the long haul and THAT is the point of financial planning, our Wealth Coaching process and working through change to make different and better financial decisions every day.
We can help you prioritize your goals and scope your focus.
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