Rather than focusing on net worth, My Money Blog suggests the Financial Freedom Ratio as a more meaningful barometer of your financial health and positioning for retirement.
If someone tells you that they have a net worth of $1,000,000, you might be impressed. But what if they spent $150,000 per year? If they stopped working, the money wouldn’t last very long. However, if they only spent $15,000 per year, they might already be set for life. In other words, your income doesn’t matter. Your expenses do. It may be assumed that the two are related, but that is not necessarily true. We all have the power to disconnect the two.
I’m sure somebody somewhere has already coined this term, but until told otherwise I will call it the Financial Freedom Ratio (FFR):
FFR = Liquid Net Worth divided by Annual Expenses
By liquid, I simply mean you can sell it for cash while not affecting your expenses. (Don’t count your car if you need it for work.) For example, if you had $200,000 but only spent $20,000 per year you would have the FFR value of 10 as someone with $1,000,000 but spent $100,000 per year. This also calls into focus how important spending patterns are when talking about financial freedom. Let’s say you had the 200,000 net worth and you wanted to increase your FFR from 10 to 11. You could either
- increase your liquid net worth by $20,000 and spend the same,
- decrease your annual spending by $1,820 and not earn any more money,
- or some combination of spending less and accumulating more.
Sure, it can be very difficult to keep slashing expenses, but this ratio keeps you honest as to how close you are to financial independence.
He also does some estimates of what a "good" FFR would be based on annuity pricing, and comes up with a suggested FFR of 25. (This value is pretty obvious, considering the conventional wisdom that you can safely withdraw 4% of your savings per year without eating into your portfolio.)