Understanding the Concept of Wealth Equivalents

By Christopher Music

Another frequently asked question for financial advisors is "How much money do I need to be able to retire?"

The answer is both simple and complex.

To get a real understanding of this question, you need to understand the concept of "wealth equivalents."

What are "wealth equivalents?" A wealth equivalent is the value of investments that, if those investments yield 5% per year, would provide the needed income to pay for your lifestyle. It is easily explained in an action definition:

Let’s say that you own a business or practice that provides your household $150,000 per year in salary and profit. Your business creates this income with your involvement to a greater or lesser degree. If you tried to sell this business to someone else, then it won’t be worth as much to them.

For example, a physical therapy practice my fetch 70% of the annual gross income. If the practice has a gross income of $1,000,000 per year at a 15% profit margin (including owner salary) then the practice would sell at $700,000, give or take. If the owner then takes that money and invests it for income at a 5% annual rate, then the annual income would be $35,000, a far cry from the $150,000 he made when he owned the asset. So, in this case the practice is worth a "wealth equivalent" of $3,000,000 ($3,000,000 x 5% = $150,000 income), even though it takes time and effort to earn the money.

When considering retirement, you need to determine how much money is needed annually to pay for your lifestyle. In other words, how much will it cost to live in the manner you wish to live? Let’s say, for example, that you spend $150,000 per year today to live comfortably.

How much do you need in assets to provide this $150,000 in income in, say 15 years? At the generous 5% rate of return per year, we already figured a lump sum of at least $3,000,000 will have to be accumulated to create that income.

However, that doesn’t even take into consideration the effects of inflation.

How much will inflation be over the next 20 years?

Who knows? But don’t delude yourself into believing that it will be the artificially low amount of about 3% per year we experienced from 1990-2009. It will be more like 1970-1990—5% or more. With the government and banking manipulation of the markets, I don’t see how it can be any other way.

Say we have 15 years until we wish to retire. At a 5% rate of inflation, we will need twice the income at that time to buy the same stuff we buy today. At today’s $150,000 a year, that means that we will need AT LEAST $6,000,000 in 2025 to be able to generate the $300,000 we will need to live. Based on what you’ve got invested today, is that possible?

Don’t freak out.

Instead of needing $6,000,000 in cash, you will need $6,000,000 in wealth equivalents.

That’s $300,000 in income that will have to be created through work or investment income or a combination of both.

Retirement planning is about time management — you have the choice of earning money or using it to give you time. The better you plan, the more time you’ll have.

If you want to have some time in the future to pay your bills and you don’t want to go to work every day, then you will have to have some money set aside to create that income. The only way I know how to do that is to save and invest it — taking at least 10-20% of your income off the top every paycheck. Sorry, but that is the way it is.

That’s why most professionals will want to stay involved in their practices rather than selling outright during retirement. Most people just won’t accumulate enough in other investments to generate the needed income. But that really is okay, as long as you know how to manage a practice on one day a week (don’t laugh, it’s done all the time).

There is always a solution. After 18-plus years of being a financial planner, I decided there had to be a better way. One of them is "wealth equivalents." Get with a knowledgeable financial planner and work out how you can accumulate your wealth equivalents so you too can have an enjoyable retirement.