Net Worth Considerations

[Ronstar]

Net worth is assets minus liabilities. Every business balance sheet I've ever seen does it this way. But I understand that individuals want to keep track of their investable assets, but this is not net worth.

 

[pb4uski]

Passing acctng classes, hiring and firing cpa's are easy. Getting people to think outside of the box is what seems the most difficult. Justa sayin

Whose box is one to think outside? Everyone is different. Ask 100 people and you'll get 20 different views or more.

That is why they are called "generally accepted" accounting principles, because they are a broad consensus of preparers and users of what should be counted and not and how it should be measured .... and not just the opinion of any yahoo with a keyboard.

 

[Helios]

I agree that gaap are accepted, but generally only by accountants. This board has equally talented people who have carved out unique ways to re. Recognition of those different methods that could enhance what we all knew as nw, might just allow us to grow past this discussion. Accountants come up with their gaap's without much strain, seems we could come up with our own terms.

 

[photoguy]

Since I'm sure there will be a rukus as to why SS and pensions are not included, let me explain - since benefits are generally subject to someone being alive at the time the benefit is received (or thereabouts) there is uncertainty as to whether the benefit will be received so life contingent benefits are technically contingent assets and are not recognized. The resolution of the contingency (the beneficiary being alive is an event that results in recognition of the asset - a receivable for that months payment if applicable).

I understand the importance of having standard definitions/GAAP but a future income stream due to SS or pension has monetary value today even if there are contingencies which may result in no payment whatsoever. E.g. one can obtain a pension advance a get a lump sum now. There's also stories of students who sell a percentage of their future income for a lump sum today.

 

[meierlde]

I guess the way to look at it is if you follow the 4% (or other) rule and have an amount you need to have in income, the amount is reduced by pensions and social security as firecalc does. It should be noted that such things increase the chance of success in retirement. So if the purpose of net worth calculations is to determine if you are ready to RE, then include them as a reduction in the draw from investments. If you want to figure how much you will leave then exclude them.

 

[aim-high]

Net worth is assets minus liabilities. Every business balance sheet I've ever seen does it this way. But I understand that individuals want to keep track of their investable assets, but this is not net worth.

I agree with you regarding the definition of Net worth. The questions then become: Are Social Security and Pensions considered assets? How does one value them?

NPV calculations are relatively simple. The problem is very few people know when they're going to sop collecting.

 

[rayinpenn]

When you finally 'check out' your heirs wont care about your social security or pensions.
Ask the pensioners of Detroit or Pan Am how they value pensions?

I am very familiar with the time value of money, I can still remember the formula after all these years.
Allow me to pose this simple question - if I have dividend paying stock do I include in my net worth the value of the
At the market price or just discount the stream of cash flows? Of course we use the market price. There is no market for pensions or future social security benefits. They are totally illiquid.

I can understand why a pension holder would want to include his or her pension to fell better about their 'number'. I also find that people who spend time worrying about their net worth totally boring... "Look at me I have 3 million - yippee" Let me ask you do you sit around counting your gold coins like Silas Marner too?

Your only concern should be is: do I have enough?


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[pb4uski]

I agree that gaap are accepted, but generally only by accountants. This board has equally talented people who have carved out unique ways to re. Recognition of those different methods that could enhance what we all knew as nw, might just allow us to grow past this discussion. Accountants come up with their gaap's without much strain, seems we could come up with our own terms.

Actually, you're wrong that GAAP is only accepted by accountants. When an accounting standard is issued the board issues an exposure draft that is subject to public comment (and today comment letters are available online) from not only accountants but also users of financial statements (investors, lenders, etc), preparers (companies who prepare financial statements), industry groups and basically anyone. The board considers all the public comments in its deliberations. Also, for certain proposals that are more controversial, they have public hearings where interested parties can present their views and the board can ask questions (I've written comment letters and participated in such hearings in my past life). The process is very similar to the process of passing a law or regulation, but with less politics.

That said, personal financial statements are pretty rare and generally only seen where wealthy individuals are issuing financial statements to creditors, but IMO it is important that there be a consistent framework as to what is included in net worth and what is not. Pensions or SS that are not recognized as assets could certainly be disclosed (in a manner similar to the disclosure of contingent liabilities in the link in post #3) even though they are not recognized so users can consider those cash flows in making decisions.

 

[Helios]

I appreciate your comments about public comment periods. I did say "generally" only accepted by accountants.
In the late 80's, in a junior position, I wrote definitions for governments. Public comment periods were an important component of that process.
Actually, there is a movement today to lengthen comment periods, to reduce the quick adoption of concepts that affect us all.
Some of the definitions that I wrote and sheperded thru the processes still stand and some were modified over the years. If enlightened thinking arises, then definitions need to be modified.

This board has taken "FIRE" and used that acronym to denote our particular goals and circumstances.
What would be wrong having our own term that reflects the total worth of individuals?

 

[Meadbh]

This board has taken "FIRE" and used that acronym to denote our particular goals and circumstances.
What would be wrong having our own term that reflects the total worth of individuals?

That is not a bad idea, but the term could not be "net worth". It would need to be developed by a subgroup following member consultation, and the definition would have to be very precise.

 

[meierlde]

That is not a bad idea, but the term could not be "net worth". It would need to be developed by a subgroup following member consultation, and the definition would have to be very precise.

I suggest expected retirement income, or received retirement income depending on if retired or not. In the terms of this board that is the major question, will you have enough income to sustain you in retirement.

Let me take a far out example on net worth. Assume somehow you won the Publishers Clearing House lottery that pays 5k a week for you and a beneficiary after you die. Do you include it in net worth? Yet it clear changes the issue of expected retirement income.

 

[Meadbh]

Perhaps what we are trying to describe is the net present value of all future income streams.

 

[Amethyst]

This thread is very interesting to me. Re: assets, I am thinking that our "net worth" is actually only a percentage of what it looks like on paper, because of the high cost (taxes, primarily, but also the costs of selling real estate) of liquidating appreciated assets.

Re: pensions, calculating NPV of pensions is funky, since ours are taxed as ordinary income. Thus, the income stream is not the stated pension amount, but the amount left (about 70%) after taxes. I think NPV should be calculated on the after-tax amount.

Amethyst

 

[Helios]

Npv might be the best. Expected roi, in some cases and expected npv, for others might cover the waterfront.
If these terms are used only by this board, we just need to decide what reflects our unique reality.

 

[jkern]

Net Worth is a calculation, assets minus liabilities. Net Worth is not retirement planning. Retirement planning includes essential and discretionary expenses, income streams such as pensions and Social Security, and any available nest egg or asset to draw from.

 

[38Chevy454]

There's a difference between net worth and cash flow, and the two are often detached as we all know. Most people have both a stash and SS and/or pension. Nowadays, with pension going away and this forum being about ER, many of us have to rely on the stash to tide over till SS kicks in.

I think herein is the answer to the root cause of the confusion and hence our discussion.

Cash flow is what we think of as the general money we have available. Since for many it includes both pension and SS regular periodic payments, the actual withdrawal rate required out of the "net worth" is lower. So the technicalities of what is included as net worth becomes a fuzzy issue since some of the items are not clearly defined as one or the other. Present value of an income stream like pension or SS is not included in strict net worth typically, but it does have a direct effect. Additionally, the hosue you live in may have value, but it does not contribute to an income stream directly. Assuming the house is paid off, it is an cost avoidance in your monthly income. Same for your vehicles or other items with some value that you use, in themselves they have value, but by using them they become a cost avoidance (not counting repairs on house, cars, etc).

I think net present value is one technique to try and put a net worth type value on non-investment assets.

In my perspective, and still being in the working world for now, cash flow is what matters - how much monthly income do I have?

 

[Mulligan]

I appreciate your comments about public comment periods. I did say "generally" only accepted by accountants.
In the late 80's, in a junior position, I wrote definitions for governments. Public comment periods were an important component of that process.
Actually, there is a movement today to lengthen comment periods, to reduce the quick adoption of concepts that affect us all.
Some of the definitions that I wrote and sheperded thru the processes still stand and some were modified over the years. If enlightened thinking arises, then definitions need to be modified.

This board has taken "FIRE" and used that acronym to denote our particular goals and circumstances.
What would be wrong having our own term that reflects the total worth of individuals?

I am not an accountant, but I once took a graduate level accounting course from a very interesting teacher. He set us up the very first class. He listed the financials from two different corporations with Company A making a million dollars and Company B losing a million dollars. He then asked us which corporation would we rather own? Of course we all took the the one that earned a million, then he proceeded to show us they were the same exact company with both financial results using GAAP.


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[Cobra9777]

IMO it is important that there be a consistent framework as to what is included in net worth and what is not. Pensions or SS that are not recognized as assets could certainly be disclosed (in a manner similar to the disclosure of contingent liabilities in the link in post #3) even though they are not recognized so users can consider those cash flows in making decisions.

pb4uski... as a practical matter, I agree 100%. But from a conceptual standpoint, let me solicit your input on two specific scenarios:

1. A retiree has $1M in investments, which are included in NW, and which yield $40K per year income. Retiree sells all investments and purchases an SPIA, which also pays $40K per year income, and has no guaranteed period. Let's assume the retiree is a healthy 52 year-old, with an actuarial life expectancy of 33 years. And let's also acknowledge that SPIAs can be easily converted back to cash. Under SOP 82-1, this person's "financial position" just dropped by $1M. Are you in agreement that this accurately portrays the economic reality of the transaction?

2. SOP 82-1 excludes personal assets which have a contingency such as life expectancy. Yet accounting standards for corporate balance sheets allow recognition of certain contingent assets. Deferred tax assets, for example, represent the current value of future deductions, which are contingent upon the existence of future taxable profit. Are you in agreement that accounting standards should accept some contingencies and not others, even when they are equally probable?

 

[pb4uski]

Net Worth is a calculation, assets minus liabilities. Net Worth is not retirement planning. Retirement planning includes essential and discretionary expenses, income streams such as pensions and Social Security, and any available nest egg or asset to draw from.

You nailed it.

Another way to think of it might be by analogy to a company.

The value of a company is in part a function of its net worth, but is also a function of its projected cash flows discounted at a market discount rate and each analyst might have different estimates of cash flow. Many companies trade at more or less than net worth (book value) because of other things such as return in relation to expected returns, earnings growth, etc. If the company lands a large contract from a financially stable customer it isn't an asset until certain triggering events occur (certain services under the contract are delivered) and monies due to the company under the contract but would be an important consideration in valuing the company because it affects future earnings.

Similarly, net worth is only part of the retirement resource equation. There are other cash flows like life contingent pensions and SS that are not recognized as assets because the triggering events have not yet occurred (the beneficiary continuing to live) but are critical to retirement planning because they affect future cash flow. So someone with mid level net worth and a large life pension may be better prepared to retire than someone with higher net worth and no pension.

A natural question might be why isn't a life contingent pension recognized as an asset? IMO, the issue is that the person might receive zero future payments if they die today or many future payments if they live a long life. Would it make sense to value the pension based on expected mortality, record it as an asset, have a lender rely on it in granting credit and then have the borrower die the next day and the loan go bad because the cash flows from the pension are never collected? I think not. That why it is not recognized as an asset and included in net worth. It can be disclosed and the bank can include it or not or in part in making its lending decision.

So to a large degree net worth is what was suggested in an earlier post, that if you were to die today and your assets were liquidated in an orderly manner (not fire sale) and your liabilities were to be paid off, it is what would be left for your beneficiaries.

 

[mrfeh]

I use the simple, straight-forward definition of assets minus liabilities. The "what would your heirs receive if you died today" definition is almost as simple, although that brings things like estate taxes, life insurance and survivor benefits into the picture, which I exclude.

 

[Meadbh]

I use the simple, straight-forward definition of assets minus liabilities. The "what would your heirs receive if you died today" definition is almost as simple, although that brings things like estate taxes, life insurance and survivor benefits into the picture, which I exclude.

In my financial plan, this is called "estate value".

 

[Animorph]

As far as FIRECalc inputs, they should probably be limited to just stocks and bonds. That's what the calculator is set up to "simulate". Not rental houses or primary residences or present value of pensions or annuities or SS, or even cash for that matter. They do not behave like stocks or bonds. You can add those in as income streams outside the standard portfolio. Net worth and FIRECalc aren't compatible.

My detailed retirement plan optimizes lifetime yearly spending. It includes SS, a pension, cash, taxes, a mortgage, and different spending needs. I have to check different time periods for each spouse to avoid optimizing with an unlikely assumption. Assuming you live to 100, for example, may favor taking SS at 70 fairly strongly unless you have a fairly high rate of return assumption. Assuming two spouses die simultaneously can also be distorting. I'm not sure any of that complexity can be described in a single number of any type.

 

[Ronstar]

I agree with you regarding the definition of Net worth. The questions then become: Are Social Security and Pensions considered assets? How does one value them?

NPV calculations are relatively simple. The problem is very few people know when they're going to sop collecting.

Good question. I'm not certain of the correct answer, but I don't include pensions and social security in our net worth. I will classify them as income in an income statement (budget) when the time comes.

Net worth is a financial snapshot at a specific time. To my knowledge, there is no way to calculate a pension or social security balance at a point in time.

Businesses include accounts receivable as assets in their balance sheets. But these receivables are finite - a specific dollar amount. And generally not made as a series of payments. We did have a series of payments coming into our business once and it was classified as income on the income statement.

 

[pb4uski]

pb4uski... as a practical matter, I agree 100%. But from a conceptual standpoint, let me solicit your input on two specific scenarios:

1. A retiree has $1M in investments, which are included in NW, and which yield $40K per year income. Retiree sells all investments and purchases an SPIA, which also pays $40K per year income, and has no guaranteed period. Let's assume the retiree is a healthy 52 year-old, with an actuarial life expectancy of 33 years. And let's also acknowledge that SPIAs can be easily converted back to cash. Under SOP 82-1, this person's "financial position" just dropped by $1M. Are you in agreement that this accurately portrays the economic reality of the transaction?

2. SOP 82-1 excludes personal assets which have a contingency such as life expectancy. Yet accounting standards for corporate balance sheets allow recognition of certain contingent assets. Deferred tax assets, for example, represent the current value of future deductions, which are contingent upon the existence of future taxable profit. Are you in agreement that accounting standards should accept some contingencies and not others, even when they are equally probable?

I think any standard setter would be very reluctant to allow an asset that can go "poof" and disappear immediately like a life contingent annuity or any other life contingent asset. I would much rather defend the bizarre $1m decline in net worth in the example you created than defend recognizing an asset, having a creditor make a decision based on that asset and having the asset evaporate into thin air the next day because the annuitant dies. No prudent lender would make a loan based on such an "asset" without a corresponding life insurance policy on the annuitant so it seems sensible to me that an asset is not recognized.

Preparers can always use disclosure in such situations to let readers know of these life contingent benefits and users can make their own decisions as to how to factor them into investing and lending decisions.

 

[Cobra9777]

I think any standard setter would be very reluctant to allow an asset that can go "poof" and disappear immediately like a life contingent annuity or any other life contingent asset. I would much rather defend the bizarre $1m decline in net worth in the example you created than defend recognizing an asset, having a creditor make a decision based on that asset and having the asset evaporate into thin air the next day because the annuitant dies. No prudent lender would make a loan based on such an "asset" without a corresponding life insurance policy on the annuitant so it seems sensible to me that an asset is not recognized.

Preparers can always use disclosure in such situations to let readers know of these life contingent benefits and users can make their own decisions as to how to factor them into investing and lending decisions.

Appreciate your perspective. Just strikes me as odd that:

1. With the stroke of a CFO's pen, a completely unauditable increase in a corporation's profit forecast (which could easily go "poof" at any time) results in a corresponding increase in deferred tax assets, which in any event, cannot convert to cash for several years.

Yet...

2. A statistically sound, auditable estimate of actuarial life expectancy results in zero asset recognition for an annuity contract that can be converted back to a pile of cash in a matter of days.

Some pretty obvious inconsistency in the 2 standards. But worse, from my point of view, and I believe from the point of view of any rational creditor, #2 is a more reliable asset than #1, in terms of realizability for purposes of repaying debt.

I realize that standard-setters have to make pragmatic trade-offs, and often, consistency and expediency win over conceptual integrity. But I would hate to be the accountant who has to explain the $1M drop in net worth in my example. That's an undefendable position by any common-sense analysis.