'The rich ratio' is particularly useful when looking at the amount of money you will have in the future, in relation to the amount of money you’ll need
There are a number of different methods that are used to measure how good or bad your financial situation is, with some being more complicated than others.
The most common being what your net worth is, but even with that, it can be difficult to know if the calculation you’re using is correct. Even if it’s reasonably accurate, what purpose does it really serve?
I want to share with you a quick and easy to understand calculation that I like, and it’s called the rich ratio.
The simplest tools, in my opinion, are the best and this one is particularly useful when looking at the amount of money you will have in the future, in relation to the amount of money you’ll need. It’s very useful to get a reference point or number you can benchmark your personal situation against and the rich ratio gives you just that.
The term rich ratio is a bit misleading, because the ratio applies to everyone, regardless of their income levels. In fact, the amount you earn in many ways is largely irrelevant.
The ratio is calculated by dividing your income by the amount you spend. And anything with a ratio over one is great; you have more than you can spend, and as a consequence you are likely to be a happy person, at least when it comes to your finances that is.
Anything less than one means you’re spending more than you have, and understandably, you’re probably unhappy with your financial situation.
Let’s assume Peter is coming close to retirement and he has built up a pension that will pay him €21,000 per year. He is entitled to the maximum state contributory pension of €12,000 and has €2,000 from another source as well.
Peter has a total annual income therefore of €35,000.
If the amount Peter needs to spend each year to have the life he wants is €30,000, then his rich ratio is 1.16 (€35,000/€30,000). Peter is likely to be a happy retiree.
Let’s look at Paul who is financially much worse off than Peter, despite the fact he earned a higher income during his lifetime and saved a lot more.
How could that be you might wonder? Well let me explain.
Paul accumulated a pension fund of €1,500,000 during his working life which pays him an annual income of €60,000. When combined with other income sources, his total income is €72,000, so you would think he must have no worries and is blissfully happy.
That would be the case, if he spent less than €72,000 each year. But Paul likes to travel, he owns an expensive car, is a member of an expensive golf club, and has a lifestyle that costs him €85,000 each year. As, a result his rich ratio is 0.84.
So, even though he had a high income and high savings, because his rich ratio is < 1, he is not rich at all, simply because his outgoings exceed his income.
You could have saved a much lower amount over your working life than someone else but that doesn’t mean you are worse off than them. In fact it could be the opposite. If your haves (income) are greater than your needs (outgoings) it doesn’t matter how much you have saved – the key is how much you spend.
And that’s sometimes lost when people look at how much they need at retirement; they think the key to a happy retirement is measured by how much they have accumulated. While that is important, what matters more is the amount you spend each year. That’s the number you have to be most mindful of, because it influences how much you need to save.
If you want a quick and easy way to figure out whether you are on track to a happy or unhappy retirement, then consider using the rich ratio as your benchmark to measure how you are doing against.
Have (Income) / Need (Outgoings) = Rich Ratio.
If your ratio is > 1 then you are on track to have a happy retirement, if it’s < 1 then changes need to be made.
Because a person’s financial situation is a factor in whether they are happy or not, and we shouldn’t pretend otherwise, it might just vary from person to person, the rich ratio can predict what someone’s happiness and quality of life might be like when they are older.
You don’t have to wait to find this out, when it’s too late to do anything about it, or for a pension statement to tell you either, which they never do.
You can discover it for yourself very quickly and easily, and I would encourage you to figure out what your rich ratio is.
And keeping this number in mind and knowing what yours is and what side of 1 you’re on, will give you a much better chance to stay on track or make changes now that will put you above one, and on the right path to a happier life and financial security when you’re older.
Liam Croke is MD of Harmonics Financial Ltd,
based in Plassey. He can be contacted at email@example.com or www.harmonics.ie