Monday, January 11, 2021

The Right Way to Calculate Net Worth

A few years ago, Robb Engen wrote an article with the same title as this one.  He convincingly defended his method of calculating net worth.  I don’t think he’s wrong, but his method doesn’t work for me.  The reason is that he calculates his net worth for a different purpose than I do.

The idea of Assets - Liabilities = Net Worth is simple enough.  What’s the debate?  It turns out that what to count among assets and liabilities isn’t always obvious.  Robb says “The correct formula for calculating net worth is the one you use consistently over time to measure progress. That’s it.”  Implicit is the idea that your goal is to measure progress.  At my stage of life, my goal is different.

When I was younger my main purpose in calculating my net worth was to measure my financial progress.  However, as I approached retirement I became more interested in how much I could safely spend each month during retirement.  This different goal puts new requirements on how I calculate net worth.

Other goals are possible as well.  Below, I list three different reasons why we might calculate net worth, and then go through various assets and liabilities to see how they would be included in net worth for the different goals.

Personal Progress

Am I gaining or losing ground in my net savings?  Unless you add up your assets and liabilities, it’s easy to focus on your RRSP or TFSA but not notice that your debts are growing faster.  You’re not overly concerned with standardizing your net worth calculation for the purpose of comparing your net worth to that of others.  You prefer a simple calculation method that tells you whether you’re getting ahead or falling behind over time.

Retirement Spending

You’re concerned with how much you can safely spend each year during retirement.  You may be approaching retirement and want to know if you’ve saved enough, or you may be retired already.  You intend to use your net worth figure to directly calculate annual retirement spending using the 4% rule or some better variant.

Assets Under Management (AUM)

You’re a financial advisor concerned  about the total assets a client brings to your practice.  Even advisors who focus mainly on their clients’ welfare still care about how a given client affects their AUM if they get paid by commissions or a percentage fee.

Now let’s go through some assets and liabilities to see how to handle them depending on your goal.

RRSP

Personal Progress:  Just add the value of your RRSP to your assets.  The extra complication of discounting your RRSP for the future taxes you’ll pay on withdrawals is unlikely to give you much more insight into the progress you’re making over time.  An exception is if you’re growing RRSP assets at the same time as growing debt.  Having $10,000 in an RRSP and owing $10,000 may seem like a wash, but it’s not because of the taxes you’ll pay to get at the RRSP assets.

Retirement Spending:  You can only spend after-tax money.  To see how much you can safely spend in retirement, you can’t just add TFSA and RRSP assets together.  A dollar in a TFSA is more valuable to you than a dollar in an RRSP.  You need to discount the RRSP assets by the amount you expect to pay in taxes on RRSP/RRIF withdrawals.  You can’t know for certain what tax rate you’ll pay, but an educated guess is better than implicitly treating it as zero.  I estimate the total income I’m likely to declare in a typical year during retirement, and work out my average tax rate.  I think many people would be surprised to learn how low this percentage will be.  I’m used to thinking about my marginal tax rate while I worked.  This is much higher than the average tax rate I paid while working.  During retirement, my average tax rate will be lower still.

AUM:  Just add the full RRSP value to the client’s assets.  The fact that the client will ultimately pay taxes on withdrawals doesn’t affect the advisor fees RRSP assets generate until the client starts to make withdrawals.

Non-Registered Assets

Personal Progress:  Just add the value of your non-registered accounts to your assets.

Retirement Spending:  Once again, you need to discount the non-registered assets by the percentage you expect to pay in taxes on capital gains, dividends, and interest.  A tricky part in this case is that some retirement spending from non-registered assets will be spending capital, which isn’t taxed.  In this case, I estimate the amounts of different types of income in a typical year in retirement, add up the capital gains taxes, dividend taxes, and interest taxes I expect to pay on my non-registered assets, and divide the tax total by the total amount I expect to spend (which includes spending some capital).  In my case, this gives an even lower tax percentage than in the RRSP case.  Once again, the tax rate we use here is just an estimate, but it’s better than using zero, which is sure to be wrong.

AUM:  Just add the full value of non-registered accounts to the client’s assets.

RESP

Personal Progress:  Contributing to your children’s RESP certainly is financial progress for your family, and adding the full value of the RESP to the asset side of the net worth calculation is sensible.

Retirement Spending:  Only include RESPs (discounted for taxes) if you think you might raid them as a last resort as you run out of money in retirement.  This scenario would likely only come up if the RESP is for grandchildren, and it would be a very difficult choice to make.  In most cases, it doesn’t make sense to include RESPs in net worth.

AUM:  As long as the advisor offers RESPs and will be managing these assets, include RESPs in net worth calculations.

House and Mortgage

Personal Progress
:  Include both the mortgage and a conservative estimate of house value in net worth.  If you plan to pay off your house steadily with no extra payments, you could make a case for simplifying net worth calculations by ignoring the house and mortgage.  However, a rising house value and a shrinking mortgage are meaningful financial progress, particularly for people who choose to make extra mortgage payments.

Retirement Spending:  A mortgage must be included in liabilities.  If you would never sell your house, then its value isn’t relevant to the amount you can spend in retirement.  If you would consider downsizing or getting a reverse mortgage, you could include a fraction of the house value in net worth.  I choose not to include the value of my house in my net worth.  However, I do have a second “net worth” spreadsheet line that includes the house.  This serves little purpose other than to show me a bigger number, but it makes me happy to see this bigger number.

AUM:  Financial advisors concerned with AUM would only care about a house if the client might borrow against it to invest more money.  However, some advisors might approach net worth calculations with a blend of the AUM goal and the different goal of preparing a net worth calculation to show to a client.  In this case the advisor would likely include the value of a house because many clients would expect it.

Pensions

Personal Progress:  Pensions such as CPP, OAS, and workplace defined-benefit pensions aren’t particularly relevant to whether you’re managing your household money well, so they can be ignored.

Retirement Spending:  Pensions are an important part of how much you can spend during retirement, so they count in net worth.  However, if you’re already collecting one or more pensions, it seems pointless to assign a present value to the pension just so that it can be turned back into a yearly spending amount.  You could certainly express your net worth as something like $500,000 saved plus $20,000 per year (rising with inflation) from CPP and OAS.  This becomes trickier if you haven’t already started receiving the pension.  I’m in this situation.  What I do is compute a present value of my future CPP and OAS benefits and add them to my net worth.  I make sure that I use the same discounting formula that I later use to decide how much I can spend each year.  This method automatically accounts for the fact that I’ll have to spend more from my savings until the pensions kick in.

AUM:  Pensions don’t generate fees for advisors and aren’t relevant to net worth.  However, clients with pensions may spend down their fee-generating assets slower, particularly if they take their CPP and OAS as young as possible.

Cars and Car Loans

Personal Progress:  Include car loans and any other debts in net worth.  Cars and anything else you own make a difference to your financial position, because they can be sold or at least delay future spending to replace them.  However, you need to draw the line somewhere between expensive items worth including in net worth and things that just don’t matter enough to track.

Retirement Spending:  As you near retirement, hopefully you have saved enough that almost everything you own isn’t expensive enough to make a meaningful difference in your net worth.  The cost of replacing most smaller things is easily absorbed into annual spending.  All debts matter, but only the largest personal assets matter.  If I had a cottage that I expected to sell one day, I’d include it in my net worth, but I don’t include cars.  Others can reasonably draw the line somewhere else.

AUM:  A client’s debts and personal assets aren’t directly relevant to generating fees (but do affect the client’s likely future total financial assets).  However, if the advisor is approaching net worth calculations with a blend of the AUM goal and the different goal of preparing a net worth calculation to show to a client, the advisor would include debts and possibly the value of cars.

Conclusion

How we should calculate net worth can get surprisingly tricky when we’re trying to estimate a safe level of retirement spending.  For most younger people who are just concerned with measuring their progress with managing their money, calculating net worth can be simple.  So, when we see others take into account different things than we do in our net worth, the reason may be that others have different goals.

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