I frequently refer to the household balance sheet as the cornerstone for financial planning. I think it may be helpful to review balance sheet basics so you'll have a fuller understanding of its use in financial planning.
You're probably familiar with a net worth statement. A net worth statement is a simplified current balance sheet, one that gives you a snapshot of your current assets vs. your current liabilities, and then suggests you are worth "x." It's a snapshot because it represents just this moment in time - it does not account for the expected future events in your life and their financial implications. Nor does it account for cash flow - current and future income and expenses.
A net worth statement is just a simple scorecard of what you have and what you owe right now, with limited use as a planning tool. Investment managers use it to suggest their investment management services will increase your net worth, but it doesn't tell you very much about how well you are progressing towards your goals. It's a tool for selling investments, not for serious financial planning.
The household balance sheet, on the other hand, accounts for current and future assets and cash flows, so that you can judge whether your current assets are sufficient to meet your future expectations about spending - expenses and liabilities. It's the only financial tool that can tell you now whether you are ahead or behind in funding your future goals, especially funding retirement, while there's still time to make significant adjustments.
On the asset side of the balance sheet, Financial Capital is the current value of your savings and investments. Human Capital is the present value of all your future earnings from employment.
The PV formula in Excel calculates this by using your current earnings, the number of years you expect to have earnings until you retire, and a discount rate, generally related to the 10-yr Treasury note, which is the generally accepted "risk-free" asset used in planning. Today that rate is a low 1.5%, so neither future income or expense cash flows will be highly discounted on today's balance sheet - a consequence of the low-rate environment that is a lasting effect of the Bush-era credit bubble and collapse of 2008-09.
If you are a two-income couple with 20 years until retirement earning a combined $100,000 year, you would have full cash flow of future earnings of $2,000,000. Discounted at an average rate of 2.5% over that 20-year period (rates must go up sometime, yes?), the PV of that future $2,000,000 cash flow is about $1,559,000. That's what your future earnings are worth today (in "today's dollars"). We can add an inflation factor to account for expected raises to the calculation as well.
As you near and enter retirement, your human capital drops and eventually goes to zero when you stop earning. You get one chance in life - while you are working, not later on when you are at the doorstep to retirement - to convert enough of your human capital into secure financial capital to carry you through what could be a long and therefore expensive retirement which can last upwards of 30 years with increasing medical costs as you age.
Social Capital is the present value of your expected future cash flow from Social Security benefits and pensions. We would use an inflation factor in discounting Social Security, if not your pension benefits, because Social Security is adjusted for inflation. If you are still many years from retirement, the present value of your Social Security income will be more heavily discounted over that period than when retirement arrives and benefits begin. In other words, social capital increases and becomes more valuable (has a lower discount) the closer you get to retirement. Makes sense, right?
Depending on your plans, we can add the current value of the equity in your home to the asset side of the balance sheet, especially if you intend to convert it into financial capital to be used for expenses in retirement, say by downsizing. Or if you intend to reserve some or all of it against possible long-term care expenses, offsetting that cost on the liability side of the balance sheet. Likewise, if you have income-producing assets like rental properties, partnerships, and royalties, these income cash flows are also added as a present value to the asset side of the balance sheet.
Similarly, using current expenses as a guide, we work up your expected future annual expenses, one-time costs like weddings, college tuition, and so forth, and calculate a present value for all of your expected future expenses, which goes on the liability side of the balance sheet.
At this point, the balance sheet clearly shows how well funded you are to support the ongoing cost of your expected lifestyle. In this example, the balance sheet shows a $218,000 cushion - a surplus, that after some further analysis to identify needed Reserves for current cash flow and unexpected expenses, becomes Upside. Upside is the amount of surplus on your balance sheet that can be exposed to market risk for future growth without jeopardizing your lifestyle. Upside can also be called the "risk capacity" of your balance sheet.
I've described the straightforward math that identifies your goals (your liabilities) and your resources (your assets) on your household balance sheet, and how well they line up over the rest of your life. This lets you do two important things:
- Adjust your goals (spending) and your resources (savings) so they align better over the long haul, and
- Create an asset allocation plan for prudently investing the Upside risk capacity of your balance sheet to support your long-term goals
Working from your balance sheet, you take only the risk you can afford to take. Your balance sheet points the way, not investment fads or simple-minded risk tolerance quizzes, the rants of investment gurus, or the relentless hype of Wall Street investment managers pushing the next surefire strategy.
Next time we'll talk more about how we use your household balance sheet as the center post of your lifelong financial plan. In the meantime, you can learn more about the household balance sheet by visiting the Retirement Income Industry Association website.
Let me know if you have any questions!
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.