Updated on 03.21.10

Every Sunday, The Simple Dollar reviews a personal finance book or other book of related interest.

One thing I often do when looking for books to read and review for The Simple Dollar is simply go to the “new releases” section of my local library and browse the personal finance new releases. That is exactly how I stumbled upon Your Money Ratios by Charles Farrell.

My usual method of deciding whether to review a book is to simply study the dust jacket for a moment, seeing if there’s anything there that gives me an indication I should stay away (like talk about “financial apocalypse” or something else wholly fear based). I usually then open the book to several random places and see if I find anything interesting, and if I’m still unsure, I’ll take the book to a chair and read the first chapter or so.

I popped this book open to the start of the first chapter and was immediately intrigued. Let’s see what exactly Farrell has to say in this book.

1 | The Capital to Income Ratio
Farrell opens the book by arguing that, by the time you retire, you need to accumulate 12 times your annual salary, which will put you in the position to live on about 80% of your annual income. The “12 times” number comes about from an assumption that your money will return, on average, 8% a year. Thus, if you feel like that return is too optimistic, you should have a higher “times” number.

Let’s say you make \$50,000 a year – not in take home, but in total income before taxes. Farrell argues that you need to have \$600,000 saved for retirement. Then, each year, you would withdraw \$40,000 (80% of your salary) of that \$600,000 and leave the rest invested. In order to maintain the same balance of \$600,000, your investment would have to earn 7.15% – and, ideally, it would earn a little bit more than that to help you keep pace with inflation.

2 | The Savings Ratio
In order to achieve that goal, you need to be saving some portion of your income. In some form or another, Farrell argues that you need to be saving 12% of your income (if you’re 45 or under) or 15% of your income (if you’re over 45). This means savings that you’re retaining, not savings that you’re simply spending in a year or two. The most common place people put this is in their retirement savings.

3 | Social Security
Farrell makes an impassioned argument about the long-term stability of Social Security and argues that it will make up around 20% of the average American’s retirement income. I tend to plan for retirement assuming nothing from Social Security, as I intend to look at any Social Security checks I receive as icing on the cake.

4 | Where to Save Your Money
As you sock away money to meet that “twelve times” goal from the first chapter, your priority should first be to your 401(k), then to your IRA, then to other investing options. I think that’s reasonable, though I think there are some fair arguments one could have about a Roth IRA versus a 401(k). You need this savings to be automatic, so set up automatic deductions from your paycheck or automatic transfers out of your checking account to cover this savings.

5 | The Debt Ratios
This chapter looks at the simple question of whether debt can help you to move from being a laborer to a capitalist. In a narrow sense, yes, it can, as debt can reduce the monthly cost of your housing and other needs in the short term. However, if you don’t pay off that debt at a reasonable rate – or if you acquire high-interest consumer debt – your debt will hold you down. His big point is that borrowing for a mortgage is pretty much the only significant debt an adult should acquire and that it should at most be two times one’s household income.

6 | The Investment Ratio
If you’re under sixty, Farrell recommends having half of your investment in stocks and the other half in bonds. If you’re over sixty, it should move more towards bonds. This is a pretty conservative investment stance, one that would be a bit of a stretch to get the 7% return that Farrell claims you will need in the first chapter. I think it’s reasonable, though, to park your money in a target retirement fund, as these will provide the same “more conservative as you age” effect, but add more risk and reward when you’re younger.

7 | Stocks and Bonds 101
Two things are needed here: rebalancing and diversification. Your stock investments should be spread across lots of different companies, including international ones, big ones, and small ones. Your bond investments should largely be in government bonds, but should be diversified there as well. For rebalancing, each year you should move money between the stocks and bonds to restore the overall 50-50 balance described earlier.

8 | Ignoring Wall Street
Don’t spend your time worrying about what Wall Street is saying. They’re often worried about the short term – the next few years – while you’re not really that concerned about it at all. You’re worried about the long term, something rarely discussed on CNBC. Don’t let it worry you.

9 | The Disability Insurance Ratio
Farrell recommends getting coverage equal to 60% of your income, which will roughly amount to your current income after taxes. This payoff will largely replace your current take-home, which means your current standard of living won’t be significantly altered by a disability.

10 | The Life Insurance Ratio
Your life insurance should be a term policy that pays out 12 times your salary minus your capital-to-income ratio (discussed earlier). So, for example, if you make \$70,000 a year, your total of your capital and your life insurance benefit should be \$840,000 per year.

This, of course, means that as you save more, you should need less life insurance. Thus, a twenty or thirty year term policy might not have to be renewed at all once the term ends.

11 | The Long-Term Care Insurance Ratio
You should start looking into long-term care insurance in your mid-fifties, not before. Before that, the risk is so low as to not be worth the cost. After that, your risk goes up enough that the cost might be prohibitive. This chapter is easily the most complicated in the book, but it also has a fairly small target audience (people in their fifties).

12 | Health Insurance
Farrell’s argument here is that health insurance is going through major reform and thus the best thing you can do to insure yourself the lowest cost on health insurance is to simply focus on yourself. Keep fit. Eat well. Doing these things will keep your health insurance costs lower and extend your healthy lifespan.

13 | Getting Professional Help
If all of this is too complicated, Farrell advises seeking a professional financial advisor. The factors you should look for are competence and training, ethics, and independence. Beyond that, I recommend seeking a fee-based advisor who doesn’t have a financial stake in pushing you towards certain investments. Farrell offers a few warning signs of a bad advisor, particularly one who promises over-the-top returns or anything like that.

Your Money Ratios succeeds in setting up a handful of numerical “rules” for people to simply follow – and if they follow them, they will find themselves in a reasonably good financial spot. In places, the book does a good job of explaining the “why” behind the ratio and the numbers are largely based on good principles (though I think the predictions about future returns are a bit strong).

If you like numbers but are pretty uncertain as to exactly how to calculate what you’ll need for retirement and for other purposes, Your Money Ratios is an excellent book for you to read.

1. JoeTaxpayer says:

On the capital ratio – he assumes a 5% withdrawal, a bit more than the 4% I suggest.
5% of that 12X is 60%, the other 20% from SS.

The book lays out a process, a way of approaching the issue. I think it a good starting point, but one needs to adjust for their own comfort. Me, I’ll ignore Social Security, and assume 4%. So I need 20X to replace my income at 80%.

Joe

2. Why aim for replacing 80% of one’s income? It seems much more realistic to replace 100% of one’s expenses. If you can live on 20 to 40% of your income, it is less a hurdle. If, on the other hand, you live on 90 to 110% of your income, you are in a lot of trouble. Just one more reason to live frugal.

3. George says:

Agreed with #2… If you’re currently saving 25+% of your income, there’s absolutely no need to replace 80% of your income at retirement as you’re not even using that much!

This book is focused on a very narrow segment of the population: those that consume rather than save.

4. George says:

Agreed with #2… If you’re currently saving 25+% of your income, there’s absolutely no need to replace 80% of your income at retirement as you’re not even using that much!

This book is focused on the consumer segement of the population rather than savers. It does nothing for the people striving to retire early and offers average advice for the normal path to retirement.

5. Moby Homemaker says:

Social security??? Yeah, right.

6. moom says:

The usually accepted number is that you shouldn’t withdraw more than 4% a year from a portfolio if you want to be sure you won’t run out of money. So you need a 25 times ratio. Of course, that ratio should relative to your consumption not your income. So deduct mortgage payments, retirement, and other savings from your income and then multiply by 25. Of course if you are planning on getting US style Social Security (in Australia for example it is means tested – if you have more than about \$1 million you’ll get zero from the government) or a company pension you should deduct those amounts too before multiplying by 25.

7. This article gives you some great benchmarks to go by. Its so hard to know how much is enough in a lot of these areas. And you can’t really rely on the people selling you these products, because they’ll usually try to sell you too much

8. SLCCOM says:

Yes, you should have at least 100% of your current income in retirement. You WILL be spending a lot more on health care as you get older, no matter how you eat and exercise. Your hearing will fail and you will need hearing aids. Ditto your vision. You’ll likely develop cataracts,and possibly macular degeneration. You’ll be getting arthritis, your cancer risk increases, your heart will get weaker, your kidneys will not be what they once were. You might well be seriously injured and survive with disabilities — and they are ALL expensive. We are designed to die, and not all the magical thinking in the world will prevent that. So plan for it!

9. getagrip says:

If you’re already spending 7.65% on Social Security/Medicare and saving 10-15% of your pay for retirement, both of which are expenses you will not have when you retire, equally 17.65-22.65% of your salary, then you don’t have to plan on living on 100% of your pay to maintain your standard of living because you are currently only living on somewhere between 82.35-77.35% (i.e. 80%).

While medical expenses can go up, other expenses, like paying for additional food, electricity, clothing, etc. for your teenagers, typically go away. Consider if you won’t have a mortgage (maybe 10% of your current income), won’t have to save for college anymore (say 5-8% of current income), may not need two cars (2% of current income), may be able to downsize the house, etc. all of which can seriously reduce what you need when you retire. Assuming you’re going to spend more than 20% in health care above and beyond what you are currently spending is a lot, especially with many of the other decreases in there and frankly, if you have all the conditions SLCCOM mentioned, you’re not likely spending your money on expensive vacations or other luxuries at that point anyway.

Finally, these are just guidelines to get you started. You need to adjust for your future and your wants, and you’ll adjust along the way. Just don’t be freaked out and do nothing. Start small, start early, build and adjust it as you go.

10. getagrip says:

If you’re already spending 7.65% on Social Security/Medicare and saving 10-15% of your pay for retirement, both of which are expenses you will not have when you retire, equally 17.65-22.65% of your salary, then you don’t have to plan on living on 100% of your pay to maintain your standard of living because you are currently only living on somewhere between 82.35-77.35% (i.e. 80%). This is where I think most financial folks get the 80% number from, its a defacto 100% of you current salary.

While medical expenses can go up, other expenses, like paying for additional food, electricity, clothing, etc. for your teenagers, typically go away. Consider if you won’t have a mortgage (maybe 10% of your current income), won’t have to save for college anymore (say 5-8% of current income), may not need two cars (2% of current income), may be able to downsize the house, etc. all of which can seriously reduce what you need when you retire. Assuming you’re going to spend more than 20% in health care above and beyond what you are currently spending is a lot, especially with many of the other decreases in there and frankly, if you have all the conditions SLCCOM mentioned, you’re not likely spending your money on expensive vacations or other luxuries at that point anyway.

11. SLCCOM says:

You are sadly underestimating the medical costs, which are going up far more than inflation. With two non-terminal but serious conditions, about 60% of our income is going to prescriptions, copays, supplements(prescribed), hearing aids, glasses, etc. And yes, we certainly are healthy enough to be enjoying going on expensive vacations and luxuries.

We don’t have teens, we don’t pay Social Security, our cars are near junkers (but run well), and fully paid for. We do still have a mortgage. And most people should plan on paying for two long-term care insurance policies, which we are not.

Not everyone will end up in our boat, but many of you will. I strongly suggest that you plan for it!

12. SLCCOM says:

Just to clarify: we are NOT going on expensive vacations and enjoying luxuries… We just WOULD be able to enjoy them!

13. SLCCOM says:

Also to clarify more: just because someone has serious health conditions such as heart disease, kidney disease, etc., it does NOT mean that you can’t still enjoy life. Temporarily able-bodied people seem to make that assumption. Even people who are dependent on a ventilator to breathe can enjoy life, if they can afford to.

14. Sean says:

How on earth can this guy say with a straight face that you will earn an 8% return with a 50-50 equity/bond allocation? And how can he be so conservative on asset allocation, while being so cavalier about total asset base requirements?

That “12x” rule is absurd. You would need to earn 10% to pay expenses and keep up with inflation. One down year in the market, and you’re totally screwed.

I don’t have a lot of knowledge of insurance, but simply on the basis of that first rule, you should absolutely not be recommending this book for anyone.

15. AnnJo says:

I don’t pretend to understand everything in the new health insurance reform package – I’m sure no one does – but there are several provisions I’ve read about that could have serious effects on these ratios.

First, I believe that something like our current Medicare taxes will be imposed on investment income. I don’t know if that will be the 1.45% that is now assessed on employees’ wages, or the 2.9% total, and I don’t know whether it will be imposed on otherwise tax-deferred investment income being earned witin IRAs and 401(k)s. I also don’t know if it will be imposed on the total distributions from IRAs/401(k)s, but I can’t imagine it would generate enough revenue otherwise.

Second, even after the housing crash, many homes of people nearing retirement have huge built-in capital gains (mostly inflationary). And the year you sell your home to move into more suitable retirement housing, you will be one of those “rich” people who is expected to heavily subsidize the health care of the rest of the nation through higher tax rates. Add that to the sunset next year of the reduced capital gains tax rate and add various state and local new or higher taxes, and people who need to sell a home for retirement (or a business) will take a real hit.

Third, the mandates being added to insurance plans (must cover preventive care, no annual or lifetime caps, must cover “wellness” and substance abuse treatment, etc.) are going to cause health insurance premiums to skyrocket in the previously pretty affordable individual market. The self-employed are going to face some real sticker shock. I’m estimating my premiums – currently \$305 a month – could rise by 150% or more. For 32 years, I’ve calculated carefully whether it pays for me to buy coverage for all the “bells and whistles” and learned it does not. Now, I’ll be forced to regardless – basically a 150%+ tax on my health insurance premium, and a big hit to my retirement budget.

Finally, although I share Trent’s distaste for the “financial apocalypse” books, we do seem to be heading into a perfect storm of unsustainable deficits and debt, growth- and wealth-killing government policies, underfunded public pensions, and nearly worldwide demographic stress (longer old age and fewer replacement workers). Assuming 8% real investment growth seems pretty optimistic, especially with a conservative asset allocation including 50% bonds, while a more aggressive allocation carries a much higher risk of loss of principal.