How is your wealth split between lifestyle and investment assets?


How is your wealth split between lifestyle and investment assets?Your Investment Wealth Ratio is revealing

In our previous article, we introduced the Personal Financial Dashboard – our six chart, graphic format for capturing clients’ progress on the path to their version of financial independence. We also discussed in some detail Chart 1 of the Dashboard, that shows both historic and projected growth in net worth and net wealth.

But absolute measures of net worth and net investment wealth don’t, on their own, tell us much about financial independence. For example, net investment wealth of $2 million may be more than enough if you only spend $60,000 p.a. but totally inadequate if you want to support a $150,000 p.a. lifestyle. Charts 2-6 serve to collectively provide a sharper picture of what financial independence entails.

In this article, we will focus on Chart 2, the “Investment Wealth Ratio”. It is calculated as Net Investment Wealth divided by Net Worth. The “Investment Wealth Ratio” for Mr John and Mrs Joan Johnson (real example, fictitious names) is shown below:

How is your wealth split between lifestyle and investment assets?

The “Investment Wealth Ratio” measures the percentage of total wealth (i.e. Net Worth) held as Net Investment Wealth (i.e. Investment Assets less Debt). The rest of total wealth is, by definition, held as lifestyle assets (i.e. residence, holiday home, cars, furniture etc.).

When the Johnsons first became clients in 2001, their Investment Wealth Ratio was about 20% (implying about 80% of their total wealth was held in lifestyle assets). Currently, 13 years later, the ratio is 72% (with only 28% of wealth held in lifestyle assets). A change of this magnitude doesn’t happen by accident!

What is an appropriate Investment Wealth Ratio?

As a rough “rule of thumb”, we look for the Investment Wealth Ratio to be above 55% to be consistent with financial independence. If the ratio is below 55% at retirement, for example, our experience suggests that the retiree is highly likely at some stage to be forced to sell (or borrow against) lifestyle assets to maintain a desired lifestyle. It’s an indication that you’re living beyond your means with too much focus on lifestyle and too little on building your investments.

To make this more concrete, consider a Sydney couple just prior to entering retirement, at age 65, with a net worth of $5 million. Of this, $3 million is held in lifestyle assets, comprising primarily a nice residence in a desirable, affluent area. They have $2 million of net investment wealth to support their desired lifestyle. Their Investment Wealth Ratio is 40% and below our benchmark of 55%.

Again, as a rough indicator, we would suggest that $2 million of net investment wealth could support an $80,000 p.a. lifestyle indefinitely. It is not our general experience that Sydney couples with near $3 million homes are likely to be content with $80,000 p.a. retirement lifestyles. $150,000 p.a. may be closer to the mark, although there will always be exceptions.

Maintaining a desired lifestyle commensurate with their lifestyle assets is likely to eventually erode the couple’s investment wealth, so that at some time a decision that is inconsistent with the concept of financial independence must be made. Either lifestyle must be reduced and/or lifestyle assets turned into cash (i.e. either trading down or borrowing against the residence).

In contrast, consider another Sydney couple about to retire, at age 65, who also have a net worth of $5 million. But they hold $2 million of lifestyle assets and $3 million of net investment wealth i.e. an investment wealth ratio of 60%, a little above our benchmark of 55%.

As rough guide, $3 million of net investment wealth could support a $120,000 p.a. lifestyle. Again, based on our experience, this would be considered a very comfortable lifestyle by those who own $2 million of lifestyle assets and don’t want to (or can’t) work again. It would be unlikely that they would ever be forced, rather than choose, to curtail their lifestyle and/or sell lifestyle assets. We consider that this indicates sustainable financial independence.

Financial behaviours may have to change to increase your Investment Wealth Ratio

If we look at the Johnson’ chart above, it highlights that in 2001 too much of their wealth was tied up in lifestyle assets. A 20% Investment Wealth Ratio and a goal of financial independence were incompatible. Some dramatic changes were necessary.

But despite some rise in the ratio over the years to 2004, it fell dramatically in 2005, reflecting a major renovation of an existing residence. Wealth was transferred from investment assets to lifestyle assets, the opposite of what was needed. However, since 2005, new savings have been diligently directed to investment assets (and debt reduction), rather than into more lifestyle assets.

With their Investment Wealth Ratio currently at 72% and projected to rise a little higher over the next 5 years, it’s suggestive that the Johnsons are already financially independent. But the distribution of your wealth between lifestyle and financial assets is only one indicator of financial independence.

In the next article, we examine another critical metric: the Retirement Expenditure Multiple.

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How is your wealth split between lifestyle and investment assets?

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