Context

One of the most challenging aspects of setting financial goals is understanding and modeling the impact of current and future financial decisions on your future net worth. Lifestyle & career choices like having children, growing your discretionary spend, getting a promotion can all have substantial impacts on your financial future but making sense of how current and future financial decisions will change outcomes is hard to imagine. 

In this article, we will use a custom built financial model that you can use for your own finances to solve this issue.

In order to provide data for us to interpret, we will use some basic financial inputs for the average American from the Bureau of Labor Statistics and then we will walk through: 

1. How to understanding the model and its inputs

2. How to interpret the model outputs

3. How to use your model to understand different financial scenarios for your personal financial goals

Once we cover these topic areas you should have a good idea on how you can use this tool to understand your financial situation and shape your own financial goals. 

1. How to understand the model and its inputs 

Often times the financial models that we are solid are opaque and we have no idea how they are derived and how they can be adjusted. This particular model is neither of these two, as it can be copied, modified, and analyzed to see all the math behind the work. 

Context: The intent of this model is to enable users to model their financial future given their current net worth, their income and expenses, and their future expectations on child rearing, investment returns, wage growth, inflation, and lifestyle creep. (This model doesn't take into account large one time purchases, as these are often today paid over time and can be internalized in expenses. It also assumes that all money saved is invested with the expected return listed.)

Inputs: 

Generally speaking, these are all relatively well understood financial concepts, that are explained in more detail within the model itself, I would also encourage you to search any term that is not clear. I will, however, briefly explain expected annual return, wage growth, and lifestyle creep because these require some additional context. 

Expected Annual Return: This is the total return you are expecting annual from your net worth. If your net worth is stored in various assets this number reflects your expected average return for these investments. A helpful bench mark for a diversified set of securities is 7-9% as that is roughly the annualized rate of return for the S&P500 for the last 40+ years, the last 20 years have been 9.87%.

Lifestyle Creep: This is a term to explain the phenomenon where households increase their spending either as a function of time or after a raise. This can sometimes result in a decreased savings rate despite increased earnings, but generally in this model it is used to quantify a growth in the expenses associated with your lifestyle. The magnitude of this figure has a significant impact on your net worth.

2. How to interpret the model outputs

As promised let's use some inputs for the average american and see what the model can tell us, in some cases we will make some adjustments to facilitate the example. 

For this example, we use the average American net worth, the average monthly income (pre-tax, because post tax would be negative), average expenses and housing cost, maximum capital gains tax, historical inflation and wage growth, and small but meaningful lifestyle creep. Not shown here is an assumption that the user will have 2 additional dependents within 8 years.

With these inputs you get the following future net worth expectation over time:

With no lifestyle changes, we can expect the average american family to be out of money in 13 years, with their Net Worth dropping below zero at this time. But why is this happening? The household seemed to have comfortable nest egg and was savings each month.

Over time the arrival of kids lead to a dramatic rise in household costs, when coupled with rising personal expenses the household's income which rose with inflation was unable to keep up with the growing expenses. The family's peak net net worth was $352,000 and within 7-8 years will be completely wiped out. So how can this household change its fortune's? 

3. How to use the financial model to develop goals

There are really only three options out of this scenario: 

1. large increase in initial net worth
2. increase in income
3. reduction or stagnation of expenses

Let's consider all in isolation to give us some basic financial guardrails. 

What net worth would this family need to sustain their expected lifestyle? 

Using the second tab in the spreadsheet, (keeping the inputs consistent and inputing a range of net worth values) we can easily see that a net worth between $1.25M and $1.5M will sustain the lifestyle of the household in question (an upward trend indicates that given the inputs you would expect to increase your net worth indefinitely. (This is why generational wealth is so critical to financial outcomes!)

What income would this family need to sustain their expected lifestyle? 

Using a similar process, we can also hold all the other inputs constant and adjust the monthly income expectation. In doing so, we realize that an after tax income of between $10,500 (+45% increase) and $11,000 (+52% increase) would make the lifestyle feasible indefinitely compared to untenable in less than 10 years. If we assume a 40% tax rate on the higher salary this would be mean you need to take home between $210,000 - $220,000 up from ~$124,000.

What cost reduction would this family need to sustain their expected lifestyle? 

Again we hold the rest constant and adjust the monthly spend value. Here it becomes clear that a reduction from $5,583 to between $4,250 (33% reduction) and $4,000 (40% reduction), would enable the average household to sustain the costs of their expectations.

As we discussed, there are three ways the american household can goal set to achieve the lifestyle they want:

1. They can find $1.25 - $1.5M in Net Worth to live off
2. They can increase their pre-tax income to $210,000 - $220,000
3. Or they can significantly reduce their spend to 43% of their existing expenses.

Collectively, these financial guardrails can give us great clarity on what we need to do to realize our financial future. In reality, we likely need to do a combination of all three to realize our goals, but knowing these values can help dictate the financial decisions we make.