Section 3: Am I OK?

What does all this mean???

So, the purpose of having information is to use it. And there’s a lot that can happen here.

Step 4:  Look at your income – what does it pay for?

To do this, start with your “Income Ratio”.  I’ll propose 3 cases here:

Case 1:  Fixed Income Case – You’re living the dream

Total Expense = Fixed + Flexible

Fixed Expense: Payments that occur on a regular basis and are essentially out of your control.

Flexible Expense: Payments that you have direct control of in timing or amount.

To do this, look at your Total Income Ratio (ratio of Total Expenses to Total Income). If this is less than 100%, then the money you get in income covers all of your expenses. You can earn nothing in investments and still be ok for now.

Pretty much, you’re done.  Like those commercials, you’ve now turned into your parents – you can live on your “fixed income” and your Nest Egg is really just there for your future.

Case 2: Some of Both – Well, you’re not doing too bad

So, if your Total Income Ratio is > 100% (i.e., your total expenses are greater than your total income), then you know that you’re going to have to spend some amount from your savings to get by. You’ll need to proceed look at your Invested Assets to figure out what you need to earn to make your dreams of ostrich riches come true.

BUT… If your Fixed Income Ratio is < 100%, then at least you know that what you get in regular pensions and such will pay for your house, your food and other essentials. The ostriches are in doubt here. They may not get locally sourced organic ostrich food; Purina Ostrich Chow ($9.99 a bushel) may suffice.

Case 3: Living off Savings – You may need to consider your Standard of Living

If both your Fixed and Total Income Ratios are < 100%, then you’re living on your assets for everything, including your basic needs (house, etc.). Those cage-free ostrich eggs can make a mean quiche if need be.

This isn’t a “worst case” scenario.  A LOT of people living on 401(k) money may be in this situation. If you’re not getting any real pension or social security, then you’ll have to manage your money to serve both purposes.

The question here is “how much do I need”? To do that, its’ time to look at your investments.

Step 5: Dig Deeper – Figure out if you can make enough on your Invested Assets to pay for all this stuff.

So, here is where you need the Minimum Interest Rate and the Minimum Savings Needed. I will focus on “Case 2” and “Case 3” here. If you’re in Case 1 (Living on your Fixed Income), all of the earnings you get go to savings.

Case 2:  Looking at your Total Income Needs.

So, with the numbers you generated, you have these things:

1. What your Total Income Needs are in $ amounts.
2. What you have to earn on current invested assets to pay for the income needed.
3. What the minimum amount is that you need invested, assuming that you made an assumed target rate of return.

Essentially:

Total Income Need = Total Income Received – Total Expenses

Min Earning Rate = Income Needed / Invested Assets

Min Inv. Asset = Income Needed / Target Earning rate

See Appendix 1 for more.

This is intended to help you talk to your investment advisor:

• The Minimum Earning Rates are the rates you need to earn on what you have. How does this compare to the investments that you have and the risks you take?
• The Minimum Amounts are the actual $ at stake.  This can tell you how far your savings is from a minimum goal.

This step is the entire reason that I had this “Idea” in the first place. You really need to figure out what your “target” long term earnings rate is for this step to work. All investment funds talk about their relative returns on earnings – they obviously can’t talk about what $ this generates. Being able to talk to your broker (or yourself if you’re your own broker, but people will think you’re strange – I speak from experience) to provide an idea of what you need to make is the first step to getting an appropriate portfolio together. 

Like the above, this breaks into a few cases

Case 2A:  Your Minimum Earning Rate is Less than your Target Rate

Because the Minimum Interest Rate and Minimum Savings Amount are mathematically equivalent, what you should see is that your Minimum Savings is less than what you have on hand.  This also means that you have a Nest Egg of savings that can generate interest for the future. 

Monitor this going forward, but no need to change course. You’re doing ok.

Case 2B:  Your Minimum Earning Rate is > than your Target, but by a reasonable amount.

Say you think your nice portfolio of invested assets can generate 8%, but the Minimum Interest Rate suggests you need 10%.  Are you at the “Point of No Return?” (I will define that later).  Maybe, maybe not.  But… you do have to watch it a bit.

If you know what you need, advisors can help you get to those needs. You do your job, and they’ll do theirs.

You can course correct in one of 2 ways (or some combination):

1. Take more investment risk and hope for a higher return. 
2. Cut expenses until you get to your target rate.

Here’s the thing – You can take on more investment risk, but if it doesn’t play out it can become a downward spiral. Make sure you work through appropriate investment risks with your advisor.

Case 2C:  Your Minimum Interest Rate is so high that it is not achievable. Time to cut spending.

If you come out with an interest rate of, say, 15-20%, do you really think you can earn that over the rest of your life?  Nope.  You are “past the point of no return” as I call it. It is time to cut your spending, sell the ostrich farm. 

The good news is that at least you have your fixed expenses covered for now.

Case 3:  Looking at your Fixed Income Needs.

This is really the same as case 2 above, but I’d suggest looking at both the Fixed Income needs before I look at the Total.  The same cases apply:

• Case 3A: Your Fixed Income Minimum Interest Rate is covered by your Invested Assets.  You probably need to consider your total spending as in Case 2.
• Case 3B:  Your Fixed Income needs are a bit higher than your Target Rate.  Assuming you’re not going to downsize your house, loans and so forth, you’re going to need to adjust.  But note – this case also means that your Total Spending is likely unachievable, and you’ll have to cut there as well.
• Case 3C:  If you need 15-20% just to stay in your house (your Fixed Minimum Rate), you’re in deep trouble.  At some point you will likely be downsizing. Just remember – ostrich eggs are rich in nutrition, and ostrich steaks are the next best thing to chicken.

Step 6:  What types of risks are you taking???

Let’s just assume you’re in Case 2A above:  The savings you have, and the investment rates that you think you need to make are achievable. Great. But is that it???

I would argue no.  You should look at your Nest Egg and your Risk Tolerance Rate.  Since I don’t like to flip pages, let me restate these:

Nest Egg = Your Total Savings (without your house) less your Minimum Invested Assets.  In other words, how much cushion you have in $ to provide for the future, emergencies and sweaters for the ostriches (I have in on good authority they like Angora).

Risk Tolerance Rate = Target Investment Rate – Minimum Investment Rate.  Or the amount you can lose before you spend more than you expect to earn on your money.

If these are positive, then you can afford to take risk.  You can go in front of the Shark Tank crew and talk about your amazing ostrich farm (and they will offer to pay you handsomely for it). OR, if it is negative, then you really have more of a savings goal either by putting more money into your savings or cutting expenses.

Comments on your Nest Egg:

• Do not view this as “Free Money” to spend as you like. Earnings on this is helping you pay for future costs.
• Nest Egg Greater than Zero = You have Cushion.   The amount that you have here generates interest for future expenses and gives you money to spend on current needs (new car).
• Nest Egg is Zero. The “Point of No Return”:  Mathematically, your Nest Egg is zero at the time that your Target Rate is equal to the Minimum Interest Rate. Now all of your savings are paying for current expenses. Or, you have “no return” on your investments going into your pocket.
• Nest Egg Less than Zero – You have a Savings Goal:    Before you retire, knowing this amount tells you how much extra needs be saved as a minimum.  After you retire, this is what you have to manage through your investment earnings and your spending habits.  

The “Risk Tolerance Rate” has the same meaning as the Nest Egg – just in percentage terms.

Ok, now let’s take stock. As of Today:

• You’ve got a budget and it makes sense.
• You’ve computed the numbers to figure out your income ratios, minimum rates and so forth.
• You’ve analyzed yourself and as of today you’re doing just fine.

But…. What about tomorrow?????

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