One of the hardest things in all of finance to figure out is whether you’re on track to retire when you want to retire. There are so many variables, ranging from how much you’ll save, to the returns you’ll earn, to how much you will actually need during retirement. And then there are countless unknowns, chief among them being how long you will live.
There are some retirement calculators that do a decent job guesstimating where you’ll stand at retirement age. But these calculators are only as a good as the data and assumptions you use to produce the results. So what’s the solution?
Well, while there is no fool-proof way to predict the future, Your Money Ratios: 8 Simple Tools for Financial Security by Charles Farrell is a good start. I’ve been a fan of Farrell’s for some time, ever since reading his paper on financial ratios several years ago. So when the publisher contacted me asking if I wanted a free review copy of his new book, I jumped at the opportunity.
The core of the book is eight money ratios (two are under the debt ratio category). In the corporate world, companies and investors use ratios routinely to assess the financial strength of companies. Just consider the P/E ratio (price to earnings) as a common example. Mr. Farrell takes the concept of ratios and applies it to personal finance.
The book covers a lot more than just the ratios, but because they form the heart of the book, let’s take a look at them in some detail:
Capital to Income Ratio: Called the CIR, this ratio looks at how much savings you have as compared to how much money you make. The ratio factors in your age on the theory that the longer you’ve been in the workforce, the more you should have saved. The book contains charts to look up your ideal CIR based on your age. The goal is to have saved 12 times your income by retirement age of 65. At 35, your CIR should be 1.4, meaning for every $10,000 in income, you should have saved $14,000.
The Savings Ratio: In order to hit the CIR target, you need to save money. The Savings Ratio tells you how much you should be saving as a percentage of your income. Depending on your age, the percentages ranges from 12% to 15%.
The Debt Ratios: Money Ratios has several debt ratios, including charts relating to mortgages and education. As an example, the mortgage ratio should be no more than 2 times your income at age 30. Of course, this is just a rule of thumb and will vary based on a number of factors, including where you live. The goal is to be mortgage-free by age 65.
The Investment Ratio: The Investment Ratio is the ratio between stocks and bonds you should keep in your investment portfolio. This is also where I disagree with the author. He recommends a 50-50 split between stocks and bonds for folks as young as 25. I think this asset allocation is way too conservative.
The Disability Insurance Ratio: The Disability Insurance ratio indicates what percentage of your income should be covered if you are ever unable to work because of a disability. For those 25 to 55, the ratio is 60%, which is generally about the most you can cover anyway.
The Life Insurance Ratio: How much life insurance you need has always been a bit of a controversial topic. Here, Farrell recommends 12 times your salary at age 25, with the amount decreasing until it reaches zero at age 65. This seems like a reasonable rule of thumb.
The Long-Term Care Insurance Ratio: As the name suggests, this covers how much long-term card insurance you should have. You can check out the book for details, but one thing here is clear–Farrell views insurance as extremely important. Notice that his ratios cover disability, life, and long-term insurance. In effect, he’s protecting your most important asset–you.
The book is definitely a good read, although the core information is also available from Farrell’s paper. The book adds a lot more detail and context, however, which many will likely find helpful. The only downside that I could see in the book is that it reminded me just how far behind we are in saving!