By most standard definitions, wealth consists of accumulated assets. In other words, it’s what you already have rather than what you earn. But most people would consider someone who’d just landed a job with a huge salary as wealthy. And someone who retires with a large lifetime pension would be wealthy in most people’s books. But does it matter how we measure wealth? For dinner table conversation perhaps not. But when it comes to long-term financial planning, it does.
Assets and liabilities
The most obvious foundation of your wealth is what you own and what you owe. Your assets consist of all your cash and investments, any properties you own, art works, jewellery, and anything else that you could sell. Your liabilities consist of any mortgages, loans, credit card debts and personal debts. Valuing your assets and liabilities is usually reasonably straightforward. Adding up your assets and subtracting your liabilities gives you your net worth. Net worth is the contribution to wealth that’s easiest to measure.
Income as part of wealth
We instinctively feel that someone with a high salary is rich. But what’s the connection exactly? For example, how much additional wealth does a £50,000 salary give you? Should you simply add £50,000 onto your net worth? No, because you’ll keep earning £50,000 year after year.
If you’re planning to retire in exactly one year, then it’s reasonable to value your £50,000 salary at £50,000. It’s actually worth very slightly less, due to the small chance you might die during the year. But say you’re planning to retire in 10 years. In that case you might multiply £50,000 by 10 giving £500,000. This time there’s a greater chance of dying during those 10 years, so you should adjust the valuation of your salary to somewhat less than £500,000. The exact calculation would be bread and butter to an actuary; it depends on your age and life expectancy. If you’re planning an early retirement, you might not need to knock off much of the £500,000 valuation. If your planned retirement date is in your eighties, then the true valuation might only be a small proportion of £500,000.
This type of calculation is called Net Present Value, or NPV. Our example shows that salary is an important factor in your overall wealth, taken in conjunction with your future plans and your life expectancy. This applies to other types of income too, not just salary.
Suppose you have a defined benefit pension based on 60% of your final salary. If you retire when earning £50,000, then you’re pension will be £30,000, typically rising with inflation each year. Most people would consider that this adds quite a bit to your wealth. In fact some people choose to cash in their defined benefit schemes before they start. The ability to do this shows that income has a measurable value.
People with defined contribution pension schemes sometimes take the reverse approach: they buy an annuity with some or all of their pension savings. This converts assets into an stream of pension income. If you do this, your net worth drops overnight; but this doesn’t mean that your wealth has dropped too: theoretically it should have remained the same.
Unlike salary income, pension income continues for the rest of your life. So life expectancy is paramount when valuing pension income. As a simple rule of thumb, you could multiply the income by your average life expectancy. Say you have a 25-year life expectancy and an index-linked pension of £30,000 a year. That would value your pension at roughly £750,000.
Annual income twenty pounds, annual expenditure nineteen nineteen and six , result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.Charles Dickens, David Copperfield
Just as income increases your wealth, regular spending decreases it. Just like income, your outgoings also have a Net Present Value. It might be tricky to calculate the NPV, but if you did, you’d need to subtract it when calculating your overall wealth.
Outgoings range from essentials like food, housing and energy to discretionary spending on entertainment, holidays and luxuries. They also include interest payments on any mortgages or loans.
What does your wealth tell you?
Calculating a realistic figure for your overall wealth is beyond most people’s expertise. But if you could come up with a number, it would give you some idea of the lifestyle you can actually afford. That might be different from the lifestyle you’re currently enjoying. You might assume that just because you’re on a good salary, you can afford a luxurious lifestyle. That might be true, but depending on other factors, you might find you need to cut back drastically in retirement. Conversely, even if you only have a modest salary, if you build up plenty of assets during your working life you may be able to continue the same lifestyle throughout your retirement.
We don’t advocate trying to come up with a magic wealth number. Not only would it be too complex, it would ignore issues around timing of income versus spending. It would also ignore uncertainty.
If you use our retirement calculator, it will take into account all the things we’ve talked about in this article, and more. It will optimise your level of discretionary spending, which could be either more or less than what you’re currently spending. This could mean that your true wealth is either more or less than you’ve previously assumed.