A Better Financial Freedom Yardstick?

A key theme from the popular book The Millionaire Next Door is the simple formula to benchmark your expected net worth.

Multiply your age times your realized pretax annual household income from all sources except inheritances. Divide by ten.

This is what your net worth should be. As an example, a 30yr old person making $100k/year should have a net worth of $300k [(30 x $100k)/10].

I've recently had in my head that I like a different simplified measuring stick a little better:
Take 3-5% of your net worth and compare that to your annual expenditures.

This in my mind gives you a better indication of where you are at relative to your expenses and risk tolerance. I think that 5% is an aggressive withdraw rate that has a reasonable possibility of wiping out your net worth over 30 years and 3% as a conservative withdraw rate that has a high probability of lasting 30+ years so the range gives an indication of where you are at depending on risk tolerance.

For us our current net worth is $855k and a 3-5% withdrawal rate would be $25.6k-$42.7k/year. Our typical monthly expenses currently run approx $5k/mo or $60k/yr including our mortgage.

I know that if I can get our annual expenses to near the $25.6k-$42.7k/year range or increase our net worth so that our expenses of ~$60k/yr are at the low end of the withdrawal range I have a reasonable view that I'm financially free. We are clearly shooting for the latter with our $2million net worth goal. With a $2 million net worth goal we would be in the $60k-$100k/yr range.

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Comments (5)

we're ahead of The Millionaire Next Door guideline but I do the same as you, I'm looking at what net worth point gets me to a comfortable retirement, I'm basing it on a 3% withdrawal, we'll retire way before 65

Posted by PFM | February 10, 2012 7:29 PM

I'm afraid instead of motivating young people to think they better get up to speed, this formula could help others become complacent. Should a 60 year old making 100k per year be feeling wealthy with only 600k net worth? Or a 50 year old with 500k?

I suppose if you figure in current Social Security benefits, these may be sufficient for retirement, but hardly could be called wealth in the U.S.

Posted by Charlie | February 10, 2012 8:47 PM

I agree with this post. Accumulation of high net worth gives a lot of freedom. I think people often overlook the potential income ones portfolio can provide.

Posted by BE @ BusyExecutiveMoneyBlog | February 11, 2012 3:22 AM

The best use of this formula would be to look at the results over a 2 year period. At ages 34-35, a person making 100k per year has an increase of 10k in net worth over those two years. Rather than using it as a yardstick for your net worth, use it for a measure of annual change in net worth

Posted by Trouthunter | February 12, 2012 3:31 PM

Pretax, pretax, pretax - NO formula or valuation should be based off of pretax income! The taxes you have to pay (aside from minimal deductions the average tax payer can take)should NOT be considered in anything! How can you realistically base any wealth indicator on $$ earned before tax?! We have to pay it...and all at different rates.

Posted by Nick | February 14, 2012 12:26 AM