Most people go into BigLaw for the money. Maybe with a side-serving of prestige. Shocker, right? Sure, we may have a vague expectation that the work in BigLaw may be intellectually challenging (sometimes it is, sometimes it isn’t), but let’s be honest. We aren’t doctors, or teachers, or artists. At least early-on in a BigLaw career, most people that are doing it would probably do something else if they had unlimited money. (This may actually start to change later on–for some people, BigLaw becomes more of a “calling” when you get more senior, the less intellectually challenging work becomes more delegated, and you’re in somewhat more control of your destiny. More on that in a later post.)
It is natural, then, to have a focus on how to measure your financial progress. And that measurement can take numerous forms. Many of them involvement discreet goals: How close are you to winning the Great Student Loan War and otherwise being free of consumer and other “bad” debt? How close are you to being able to put a down payment on a home, if you have run the numbers are determined that putting down a down payment make sense? How close are you to having set aside enough money to pay for college for your kid or kids, if you intend to do that? And, the great holy grail of this site and others: how close are you to being financially independent?
A common factor in measuring your progress toward any of those goals, though, is having an understanding of your net worth. Some people take a categorical approach to this analysis: Assets minus liabilities. Liabilities is pretty easy to identify, and everything should be included. But for people taking a categorical approach, assets includes literally everything you own that you could sell. Straightforward, right? Well, not necessarily. Do you literally include everything you own? I find that to be fairly crazy. You’re (generally) not going to sell every one of your worldly possessions to fund your needs and wants. And in any event, coming up with a specific number for most of your “stuff” is going to be an exercise in false precision.
On the other extreme, I’ve heard people exclude substantial assets from their net worth considerations. Examples include:
- Estimated Home Equity. I’ve heard people exclude home equity on the basis that it’s hard to be able to estimate (true), they have to live somewhere (true, but, of course, “somewhere” doesn’t need to mean “where you currently live”), they would have transactional costs to unlock that home equity. Those costs could take the form of all of the costs associated with selling a home and moving. That is true, but as I discuss below, those costs–and “liquidation costs” in general–can and should be estimated and deducted from your net worth calculation. Alternatively, those costs could take the form of home equity line of credit expenses. But although that liquidity could potentially be available, when thinking through net worth calculations, I simply do not take an approach that involves layering new debt into my life. My verdict: Include.
- College Funds. “I exclude the amounts I have set aside for my kid from my net worth because that money is no longer mine, it is my kid’s.” Let’s set aside the fact that for most forms of college savings, this is just (inaccurate) mental accounting, because the money is in fact still yours. It’s potentially subject to withdrawal penalties depending on your method of saving (e.g., if you are saving in a 529 plan), but that, again, could be taken into account. The reason I actually think this is an irrational exclusion is that the funds are there to replace what would otherwise potentially be a future expense, so it is a very real source of your net worth. Without those savings, assuming you are going to pay for your child’s education one way or another, you would have to raid your retirement savings, or your cash flow, to pay these costs in the future. So why are you excluding this from your net worth? My verdict: Include.
- Health Savings Account Amounts. The same logic used to exclude college savings is sometimes used to exclude savings in HSA accounts–though far less common. The same issue applies, though–this is replacing a future expense. I’d note that it is completely inconsistent to treat HSA funds differently from college funds for purposes of a net worth calculation. My verdict: Include.
- “Stuff.” I am no Marie Condo. Or Mr. Money Mustache. I have 2,000 sq ft or so worth of house, and that house has a fair amount of stuff in it. If I wanted to, I could try to estimate the value of at least the bigger ticket items–and, in fact, I have done that at a VERY high level, for purposes of setting my homeowner’s insurance policy. It’s not a six-figure amount of stuff, but it’s also not a 4-figure amount of stuff. I also have a car sitting in my driveway that I bought for $20-30k, new, a couple of years ago (with cash, of course). It has less than 20,000 miles on it and it’s a car that holds value reasonably well (though I will say that buying a new car is rarely a smart financial move–definitely a moment of weakness, on my part), so it is certainly worth more than $15k today. Some people would include the value of this stuff in their net worth calculation. I don’t. It’s not enough to matter–it’s just not worth my mental energy. My verdict: Unless one of your “investment categories” includes “stuff” like artwork and so on–and I’ll keep my thoughts on that to myself for the time being–if your “stuff” is valuable enough that it really moves the needle on your net worth, you either have way too much stuff or your net worth is low enough that you’re far from meeting most relevant financial goals.
- Expected Inheritance. I’m going to get something out of the way. I did not grow up in a situation where there was ever any question about inheritance. I wasn’t going to have a meaningful one. End of personal analysis. That being said, I have nothing against people in a different situation–they can no more help the family they were born into than I can. Nevertheless, it’s impossible for me to conceive of it making sense to factor in an expected inheritance in the future into your own financial assets–other than for people that, frankly, are in financial conditions that have no need to read this blog. Hopefully, you have no idea when it is coming. Maybe you have an idea of how much you are getting and maybe you don’t, but you have no way to know whether there will be a change in circumstances that could greatly diminish your expected inheritance. And, frankly, have some self-respect. Make your own money. Plan your own path to financial security; if you end up with a windfall, you can re-evaluate your plans at that point. But living life with the expectation of an inheritance in a way that changes how you live your own life is financially reckless, unless it is such a certainty that you are on the other side of this line and can “pursue your dreams” because you know the money will be there–in which case you’re not the target audience for this blog. My verdict: exclude.
- Social Security and Pensions. There are three bases on which people exclude social security and pension payments. All of them have some merits and some drawbacks, and they are related to one another.
- First, including these sources of income is just hard–or, for more financially sophisticated people, it’s not “hard,” but it does involve a significant amount of false precision. That’s a fair concern. Unlike some other sources of retirement income where you could access it immediately if you were willing to pay taxes and penalties, it is simply impossible to access social security and pensions early (subject to some exceptions). So the only way to include these amounts is to perform a net present value calculation for your future anticipated income streams. Even setting aside the change in law/bankruptcy risks (which I discuss below), this calculation requires assumptions around inflation, future increases in entitlement as a result of additional working years, how long you will live, and many other factors. You can typically plug all of this into publicly-available calculators and it will spit a NPV figure back at you, but it’s a “garbage-in, garbage-out” calculation. Some of these issues are similar to relying on real return assumptions to calculate whether you have reached financial independence (a subject of another post), but it’s reasonably possible to run sensitivity analyses around real return analyses–here, it’s just a shot in the dark.
- Second, if you’re talking about pensions, there is a very real pension crisis in the United States. Whether you are looking at public or private pensions, a huge number of them are underfunded to a catastrophic degree. For private company pensions, the Bankruptcy Code permits significant write-downs or eliminations in pension entitlements (subject to certain requirements); the Pension Benefit Guarantee Corporation–essentially the backstop for failed private pensions (though even then at a vastly reduced benefit rate)–has a funding crisis; and the “highly mobile” (whether you like it or not) nature of today’s employment situations means that even if you are employed at one of the companies still offering pension benefits, it is possible that you may not make it long enough to vest. Public pensions are also in bad shape (and participants in these pensions could, in some cases, face the double-whammy of not being enrolled in the Social Security program); local and state governments only have so much ability to plug those historic holes through increased tax revenue; some states are starting to explore cuts even to vested pension benefits; and local municipalities may, in some cases, be able to enact cuts to their plans through the municipality provisions of the Bankruptcy Code. The economically rational approach to all of this is to risk-adjust your anticipated future benefits to account for these risks, but trying to do that is akin to throwing a dart at a dartboard while in a pitch-black room and not knowing which way the dart board is. So many people simply choose not to include these future benefits in their net worth calculations.
- Third, if you’re talking about Social Security, especially for younger people, the “insolvency” of Social Security may seem inevitable. That’s silly–no politician would survive it. But it’s not silly to believe that changes in the program in the future are likely to be in the pike. No one has a crystal ball, but pushing out the retirement age seems almost inevitable (and it is certainly necessary–the fact that social security eligibility is not tied to life expectancy is at odds with the design of the program). Means testing certainly seems within the realm of possibility (and, depending on one’s view of the purpose of the program, could be seen as an appropriate step to preserve the program for those who need it). Reduced benefits also could happen, though in my view, it seems unlikely for that to be applied on a blanket basis to everyone, with the exception of reductions in annual cost of living adjustments. That all said, this kind of prognosticating is essentially impossible to separate from trying to factor in future changes in tax law to how you think about the value of your retirement funds. Many people nevertheless look at this picture, combined with the issues around delayed availability, and simply exclude future social security entitlements from their net worth considerations.
- My verdict: This is a very difficult area for me. I do not have pension issues to think about, which makes it easier. Like everyone else, I do need to consider how to think about social security. And I take the easy way out–I am building my financial plans around an assumption that I will not receive any social security. There is no question that this is probably an overly-conservative view, but I cannot justify to myself including an amount equal to what I would currently be expected to receive. My approach to this is flatly inconsistent with the way I treat tax exposure on my current assets (which I discuss below), but it’s a place where I have decided to draw the line. And I’ve decided to draw that line knowing it will cost me a lot of additional working time before I can consider myself financially independent. Your mileage may vary.
From here, my approach to my own net worth starts to deviate significant from other people in personal finance. And it all has to do with taxes and other anticipated expenses involved with accessing your wealth. Most people in the personal finance space appear, as a general matter, to take a “before tax” view of their net worth, on the assumption that they will be in a fairly low tax bracket when they are actually accessing their retirement savings. I cannot get behind that approach. Again, I don’t have a crystal ball, and I can’t know where tax rates and laws are going to move in the future. But I cannot justify to myself an assumption that tax rates are going to remain at historic lows indefinitely, while the United States simultaneously has ever-increasing financial deficits and, it appears, a demographic-led march toward increases in public spending programs (health, education, environmental, etc.). In fact, I support those increases in public spending programs! (I’m generally not going to be overtly political on this blog, but I’m not going to be completely apolitical, either.) Given that combination of factors, I view increased revenues as inevitable–it’s going to be that, or societal collapse, and I’m not a bunker planner. (I think a “wealth tax” is somewhat unlikely for people that have a level of assets where they are still giving serious thought to whether they are financially independent.)
Now, someone taking that full-bore would, arguably, invest in a Roth 401(k) instead of a Traditional 401(k), and I do not go that far. And it is, of course, impossible for me to actually bake in higher future tax rates into my financial planning in a way that is anything other than a blind guess. So, I do what I consider to be a middle ground: I view my net worth on a strictly current basis, by factoring in any immediate tax leakage and penalties I would incur if I were to liquidate all of my retirement funds today (though I do not take this penalty approach to my kid’s college savings or to my HSA). This includes immediate capital gains on my taxable investments, income tax on my Traditional 401(k) investments, and early withdrawal penalties to the extent they would apply to any of my retirement accounts other than my HSA. Is this overly-conservative? Certainly. But I view it as a middle-ground to attempting to calculate my expectations around future tax rates. It’s also helpful in that it takes questions of inflation out of my analysis of my current net worth.
I apply this same liquidation approach to my home equity value, by subtracting from home equity anticipated costs of selling my home. This ends up being an 8% deduct from the total value of my home.
Note, all of this is about total net worth. I can, and do, make other calculations. For instance, I keep a running tab on my liquid net worth. For that, I entirely exclude my retirement accounts and home equity, and again include the tax-effected value of my taxable investment accounts. I view my liquid net worth as my “FU money”–if I simply decided to quit my job today, what proceeds do I have available to me, and how long could I reasonably last without getting another job and without making massive lifestyle changes such as moving.
For perhaps my most important tracking of all–my “FI number”–I do yet another calculation. In that calculation, I exclude college savings and home equity, because I do not view those sources of wealth as being available to satisfy anticipated expenses, as I’m not yet to the point of thinking about relocating to help “fund” FI. But I include all other accounts (again, on a tax-effected basis). More on my thinking on my “FI number” in a later post.
So, how do you calculate your net worth? How does it differ from other calculations that you perform to track your overall financial health?