The Financial Freedom Ratio: A Better Way To Measure Your Net Worth?

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Most of you are reading this right now because you want that elusive “financial freedom”. This usually revolves around net worth, and many of us (ahem) have a specific net worth goal they want to achieve. Various formulas and calculators abound. The popular book The Millionaire Next Door suggests this formula for a target net worth:


In addition, there are various debates on how to measure net worth. Do you include your primary residence, or not? What about cars or jewelry? How do you properly account for pre-tax accounts? However, while reading this post at Early Retirement Extreme amongst others I realized that these are not the things I need to be focused upon.

Financial Freedom Ratio
If someone tells you that they have a net worth of $1,000,000, you might be impressed. But what if they spent $150,000 per year? If they stopped working, the money wouldn’t last very long. However, if they only spent $15,000 per year, they might already be set for life. In other words, your income doesn’t matter. Your expenses do. It may be assumed that the two are related, but that is not necessarily true. We all have the power to disconnect the two.

I’m sure somebody somewhere has already coined this term, but until told otherwise I will call it the Financial Freedom Ratio (FFR):

Liquid Net Worth divided by Annual Expenses

By liquid, I simply mean you can sell it for cash while not affecting your expenses. (Don’t count your car if you need it for work.) For example, if you had $200,000 but only spent $20,000 per year you would have the FFR value of 10 as someone with $1,000,000 but spent $100,000 per year. This also calls into focus how important spending patterns are when talking about financial freedom. Let’s say you had the 200,000 net worth and you wanted to increase your FFR from 10 to 11. You could either

  • increase your liquid net worth by $20,000 and spend the same,
  • decrease your annual spending by $1,820 and not earn any more money,
  • or some combination of spending less and accumulating more.

Sure, it can be very difficult to keep slashing expenses, but this ratio keeps you honest as to how close you are to financial independence.

What Is A Good Financial Freedom Ratio?
To find this, I went to the Vanguard Annuity website and looked up a price quote for their inflation-adjusted fixed immediate annuity (Lifetime income option, fixed payment, bottom right). This means that, if I give Vanguard a lump sum of money, they will give me a regular income that is adjusted every year for inflation per the CPI-U. (Annuities are subject to the claims-paying ability of the issuing insurance company, which is AIG Insurance.)

I input that I was 30 years old and wanted an inflation-adjusted $30,000 a year ($2,500 a month) for the rest of my life. The quote was $857,000. So a lifetime of my required income requires an FFR of 28.6 ($857,000/$30,000). As you get older, the number decreases.

Using the popular but controversial 4% safe-withdrawal-rate rule for a balanced stock/bond portfolio, you would need a FFR of 25 to have a good chance of living off of your investments without having to annuitize. Keep in mind the 4% value is not adjusted for inflation, so your buying power would decrease each year.

What’s My FFR?
I’m not sure exactly how much I spend per year. I need to fix this. I should be able to back out the numbers for 2007 pretty easily since I track our net worth and I just did my taxes, but I’d need to cancel out things like unrealized investment gains. Roughly, I would say that last year we spent somewhere between $25,000 to $30,000. This year, it will be much higher due to housing expenses, although one day the house will be paid off. My FFR is certainly less than 10 right now, more like in the 8 range. Single-digits! 🙁

Track Your Expenses
I like the FFR because it gives me a better idea of how close we really are to financial freedom. In addition, it reminds me that our expenses matter equally as much as our net worth. Do you know how much you spent last year? I am convinced that spending is a habit. If you spend modestly now, it will be easy to maintain this in the future. If you spend lavishly now, it will be very difficult to downgrade later on. We all have our luxuries which we hold dear, I know I certainly do, but it has to be weighed against how long you want to keep working and saving.

So, after all this I suppose I need to figure out how to gradually shift to a simpler and less costly lifestyle. Heck, forget cutting expenses, I spend a lot of effort simply trying not to accumulate more expenses these days…

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  1. I like your financial freedom ratio much more than the Millionaire Next Door’s formula, but I’m not sure how useful either is for me right now. Neither formula helps me in setting realistic goals for the next few years. I’m about to graduate from college, and I have a net worth just over $18,000, counting only savings and not my car. That would maintain my current lifestyle for about a year and a half once I start paying for my own insurance. It doesn’t put me anywhere close to having enough for retirement, but it’s reasonably good for someone who isn’t quite 22.

  2. Interesting post. I’ve never thought to use your formula. I think it’s a good starting point for seeing how well you are doing, but it is “incomplete” in that it doesn’t take into consideration your age and tell you whether you are on-track to have enough for retirement. That said, I like the simplicity of your formula. My FFR is just under 2.5, so I’m still far behind you on the journey to financial independence.

    Incidentally, I just wrote a post yesterday on calculating your expected net worth. I found 4 published formulas of calculating expected net worth, and compiled a spreadsheet as my own method to calculate my expected net worth. I know it’s complicated, but perhaps you can give it a shot and tell me what you think.

  3. “Target Net Worth” helps us realize if we’re on track to our retirement.

    “Financial Freedom Ratio” helps us realize if we are ready for retirement.

    I guess.

  4. Net worth is a pretty illusive in my opinion. What really matters is the amount of income you can produce annually from your assets. If your portfolio is 1,000,000, but invested primarily in Nasdaq Stocks, your annual income from dividends would be no more than 10,000/year. Thus you would have to rely on capital gains in order to pay expenses.
    If you could live on $1000/month, and you had a diversified mix of income producing investments like stocks, REITs, even some bonds that produced that amount from 100K in net worth, then you are better off than the millionaire guy invested in tech stocks above.

    Another concept in the so called net worth equation is the primary residence that people occupy. True, your house might be worth a lot. But when you need to access the money fast ( in the worst case scenario- an emergency for example) it will be tough to dispose of this asset. In addition to that, housing costs a lot of money. It does save you from renting though, and housing prices might increase at least on par wiht inflation..

  5. Dude, do you know your blog is mentioned in the Money magazine? I saw it yesterday in Borders. Congrats! (I never knew you’re only 29 and already achieved so much in your life. Can I reach your level in 3 years? lol)

  6. "Mo" Money says

    Interesting post. I like the comparison between the two methods. I also like the use of annual expense brought into the calculation. I will try this on my own situation.

  7. I don’t like the first formula.

    It basically says. That right now i would need 2+ years of my current income saved. I’ve only been working full time for <3 years.

    70k*24/10 = 168k I only have about 60k saved. I haven’t even earned 168k after taxes in 3 years.

  8. Duane Gran says

    The MND formula is useful as an indicator of good habits for people in their mid 30s or later. If you exceed the target net worth by a factor of 1.5 or higher using the MND calculation you stand a good chance of retiring well. People often critique the formula because it has little predictive value for people early in their career.

    The FFR is a good ratio to help answer how close you are to retirement, but in itself it won’t tell if you are doing the right thing.

    The lesson? You can’t boil it down to one number without a lot of exegesis on what that number means.

  9. My initial reaction to FFR was that of excitement. It seemed like a good ratio to remember but then if you think about it more – it is essentially “how many years I can live on my networth” if I stop working. It is a good measure for folks in the later part of their life. But for people in their 30s – 40s this would not make sense. Let us say you achieved the magic number of 25-28 for you. Would you stop their? Plus there are going to be quite a few life changing events – kids, their school, their college etc., which would change once expenses.

  10. AJC @ 7million7years says

    The only problem is that a Hobo COULD conceivably have a better FFR than a multimillionaire.

    For example: my FFR is 40 (purely based upon cash in the bank) – but, that doesn’t mean anything to you, until I also tell you one of the Scaling Numbers (either ‘liquid net worth’ OR ‘annual spending’ will do).

    If we want to keep thes numbers secret (the great benefit of the FFR), then we simply need to add some sort of Quality of Life Index.

    QLI = Current Annual Spending / Required Annual Spending.

    As long as the QLI is greater than 1, then I agree that the FFR is a great way to share ‘financial positions’ WITHOUT disclosing how much we actually have in the bank!

    As far as using the FFR (together with QLI, of course!) to determine how close your are to ‘retirement’ then, you need to compare the FFR to a suitable Safe Withdrawal rate exactly as you suggest. Nicely done!

  11. interesting. using data from yodlee, for my spending over the past 12 months, i’v spent just under 78k, but a lot of it was one time expenses, like a car, my april tax (it counts as an expense but it really should not be), excessive travel, etc. i’d say the realistic spending was just about 50k. with 220k nw, i have a ffr of 4.4, ouch. at the age of 29 i am just under my target net worth as well, which, i agree with others, is useless prior to age 30.

  12. The Authors of the millionaire next door admit that there formula overestimates how much you should have saved when you are young. However, I like the FFR, it seems a little more intuitive than other metrics.

  13. I agree with the dividend guy. If you are really looking at financial freedom, wouldn’t you want something like:

    FFR = (projected “passive” income) / (projected annual expenses)

    If FFR > 1, you are “financially free,” and sustainable. Here, you are not reducing your assets, but simply utilizing your equity. If you want to, you can complicate the formula by adding inflation, buffers in your equity, etc. But, I think you get my gist: sustainable financial freedom is independent of time (and age).

  14. Have you read “Your Money of Your Life” by Joe Dominguez and Vicki Robin? Their book is done with the FFR in mind. They talk about how much your time is worth (how much you make after you take into account stuff and extra time required by working) and how freedom comes when your investment income becomes greater than your expenses. They can get a little extreme, but the concepts they discussed were interesting.

  15. Here is my record of spending back to 1994 and it excludes charity and federal taxes (1040 & FICA). Its not quite as steady as I would have thought. In recent years I spent alot more than I probably should on stuff like recreation (gyms, workouts, events, etc.) and eating out. So it would only be a rough guess what to put in the bottom of the FF Ratio.
    94 26.9k
    95 26k
    96 33.7k
    97 39.3k
    98 35.2k
    99 59.8k paid off house, new car
    00 19.2k
    01 22.8k
    02 38.6k remodeled kitchen
    03 39k
    04 41.5k
    05 37.2k
    06 29.8k
    07 70.0k bought new car, plus some other splurges

  16. I’d like to see you track your FFR vs goal next to your net worth chart at the upper right hand corner of your blog.

  17. Thank you Jonathan;

    This is it. This is what people need to know. Your financial freedom is governed by the relative value of your assets vs your expenses (i.e: your cash flow)

    But I don’t know that everyone gets it:
    aa:“Target Net Worth” helps us realize if we’re on track to our retirement.

    “Retirement” is financial freedom. Having the ability to say: “Today is last day that I need to work” is honestly more powerful than “Today is the last day that I’m going to work”.

    Enoch ko:
    …it doesn’t take into consideration your age and tell you whether you are on-track to have enough for retirement.

    Again, what’s the difference between financial freedom and “retirement”. Don’t most people actually want financial freedom?

  18. I have been thinking about my net worth a lot in terms of # of years of annual living expenses saved. I have found it makes much more sense to think of retirement in terms of having enough to cover expenses (as we don’t intend to save much once we hit retirement, and savings a big chunk of where are income goes). So, likewise, think this can be a rather meaningful ratio of progress towards retirement. We try to save 50% of our annual living expenses every year. When we hit 40 or 45 we hope to get to 100% saved every year (as our assets grow, power of compounding and all that).

    To Paul – I just had to add our expenses are rather steady every year, but of course we have bigger purchases like cars every few years. We set aside $5k/year for bigger purchases. I personally just include that $5k/year as spending. Of course, you could also just take an average of your spending to get an idea. I don’t think anyone spends the same amount every year. But we all probably have an idea of how much we need to live on, on an annual basis.

  19. Gates VP put it beautifully. Let me expand a little on the concept:

    Read the book “Die Broke”. Just read the first third of it. The concept of retirement is so ridiculously outdated and obsolete the popular media should be ashamed of even perpetuating it. But it’s a huge huge industry now that will not fulfill the empty promises it perpetuates. You’re a fool if you buy into it.

    Is it possible to “retire now” and live the way you want? Yes, but usually you have to live through the cube slavery we call a career. It’s practically a rite of passage. Most young folks will fear the concept of “losing their jobs” as I did back in the day. Turn that weakness into a strength – become a contractor. There are downsides to being a contractor but also upsides such as getting your life back.

    This is kinda all over the place, but the bottom line is this: until your passive income exceeds your fixed costs, save every penny and invest it for passive income. And find a way to increase your personal freedom while earning more in the process. You can do it!

  20. I think the general concept you mention is a great idea and is one I have used for years. The tough part is getting the “rubber to the road” and may be why a lot of resources use the somewhat simpler net worth/4% withdrawl method.

    I think the “Millionaire Next Door” method has a slightly different angle. It doesn’t care directly what your expenses are because it’s point is to calculate how efficiently you save your income and avoid taxes (legitimately of course). Its major flaws are that it’s very harsh on those newly in the job market, and that it doesn’t have a smoothing function for income. SomeGal and I’s situation illustrates the latter issue–net worth lagging incme. Over the past 12 months, we’ve been fortunate to have huge increases in income. But because of the lag in net worth, it looks like we are terrible savers.

    With the FFR, there are different variations. For example, it’s useful both as a job loss/disaster scenario tool, but also for retirement. To be more specific, we use it more for the former. But it’s complicated: we both have W2 type incomes, but we both also have secondary and even tertiary income sources. And on top of that, there are unrealized cash flows that could be realized if needed. So even in a simple and common scenario dual-income family, do you remove both or only one income for the calculation? For job loss or freedom to change careers, I usually remove the biggest income but include the others.

    On an aside, to the person who mentioned the primary residence’s equity: it depends again what the purpose of the calculation is for. If it’s for job loss, I think it should be included. One should get a HELOC open BEFORE there is an issue, but leave it alone for emergencies only. If the calculation is for retirement, then it’s a matter of are you able/willing to sell for something cheaper?

  21. This is sort of related to your post above. I have a discussion topic request….are any of your readers being impacted by the “economic downturn”? Sure, we pay more for gas and groceries have gone up, but is anyone really struggling to make ends meet more than they were, say, a year ago?

    I’ve made some adjustments (shop at Wal-mart, work from home more often, etc.), but have I seen a REAL downturn in my income? Not really. What about others?

  22. Plugging my financials into those numbers gives me some dissapointing results…ah well back to the drawing board.


  23. IS this how you measure Financial freedom? I am currently looking for indicators of financial freedom and I am not sure if I can use this. Also, was this formula already used in other studies? Thanks!

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