The Augmented Household Balance Sheet
Every household has a balance sheet, whether they know it or not. The balance sheet shows the value of assets, the book value of debts, and the difference which is net worth.
Assets include financial assets (FA) like stocks, bonds and deposits, and real assets (RA) like real estate, precious metals and durable goods. Debt (D) includes mortgage debt, credit card balances, auto loan debt and student loan balances. Net Worth (NW) is the difference between total assets and total debt.
The Flow of Funds (FOF) is a quarterly publication from the Federal Reserve that estimates the aggregate value of assets, debt and net worth for the entire Household Sector. The most recent reading is September 2020. At that time total Household financial assets were $98 trillion, total real assets were $42 trillion, and total debt was $16 trillion. By subtraction, total Household net worth was $124 trillion. If we divide total net worth by the number of households (120 million) we get “average” household net worth of $1,033,333. This doesn’t seem to ring true. Separately, we know that only about 10% of households have net worth of $1 million or more.
What is going on? The answer is, of course, that the wealth distribution is highly skewed and the “average” is not a good measure of the typical household. To get a better idea of how the typical household is doing we can look at another Federal Reserve publication, the Survey of Consumer Finances (SCF). The SCF is a tri-annual detailed survey of the financial condition of roughly 5,000 households. The survey shows the distribution of household income and net worth by age, education and race. The latest data are from the 2019 Survey and show that median household net worth in 2019 was $120,000. The median household had a home valued at $220,000, financial assets totaling $100,000, mortgage debt of $180,000 and consumer debt of $20,000. Net worth was greater for older households and households headed by college graduates. Median net worth for households headed by someone 65-74 years old was $266,000 compared to $14,000 for households headed by someone under the age of 35. Median net worth for households headed by college graduates was $308,000 compared to $74,000 for high school graduates.
While highly useful, the SCF ignores some important concepts. On the left-hand side (the asset side) of the balance sheet), the SCF (and the FOF) ignore the present value of future wage and retirement income. On the right-hand side (liability side) the SCF ignores the present value of future consumption and legacy. What I call the Augmented Balance Sheet includes these important categories of asset and liability.
The Augmented Balance Sheet
Some economists use the term Human Capital (HC) to denote the present value of future (after-tax) income. To estimate HC for a given individual, you need to estimate current after-tax income, the growth rate of income, and the number of years between today and retirement. Once we make these assumptions, the calculation is easy, HC = Current Income multiplied by a Present Value Factor (PVF). The PVF is derived using a series expansion formula from high school algebra, namely
(X1+X2+…+XN)=X(1-XN)/(1-X) where X is the ratio of (1 + growth rate) divided by (1 + discount rate). If X=1 the formula reduces to NX.
Adding HC to the right-hand side of the balance sheet improves the picture dramatically for everyone who is not retired, younger people in particular. HC for a young college graduate earning median income is about $1.5 million. Since retired people have zero HC, it appears that adding HC turns the tables completely – younger households are richer!
Oh wait. Young people also, by definition, have a more years of spending in front of them. Just as the present value of future income may be viewed as an asset, the present value of future spending is a liability. Another liability is the present value of any “legacy” or “family money” that you intend to leave for your heirs or favorite charity. Also, an additional asset is the present value of future retirement income.
Thus, the Augmented Balance Sheet includes the following:
Total Assets = Assets + HC + PV(retirement income)
Total Liabilities = Debt + PV(Consumption) + PV(Legacy)
One use of the Augmented Balance Sheet is to assess the level of current consumption that is consistent with financial resources and objectives. Since balance sheets must balance, we have Total Assets = Total Liabilities and we can “solve” for the present value of consumption as
PV(Consumption) = Total Assets – Debt – PV(Legacy)
We can write PV(Consumption) as the product of current consumption and a present value factor PVFC
Consumption * PVFC =Total Assets – Debt – PV(legacy)
So
Consumption = (Total Assets – Debt – PV(legacy))/PVFC
This equation provides a useful tool for determining the level of current consumption that is consistent with your total financial resources and obligations.
Example
Consider the household with age=40, planned retirement age=65, current income=$75,000, projected income growth of 2% (net of inflation), expected Social Security of 40% of income at retirement, zero real growth of Social Security, and planned legacy of zero (die broke). Finally, suppose the goal is to increase real consumption spending by 1% a year from now to expected mortality at 100. The equation above can be used to calculate the level of annual consumption spending today that is consistent with these assumptions. The answer is $61,000. This implies a current savings rate of 18%
(1-$61,000/$75,000).
If you want to leave a $1 million legacy, you need to raise your savings rate from 18% to 22%.
On the other hand, if you are willing to assume 7% real after-tax rate of return instead of 3% (like many pension funds) then the required initial savings rate is 3%.
I have created a simple spreadsheet that does this calculation. The inputs are listed below in bold.
Age
Retire Age
Current After-Tax Income
Real Growth Rate of Income
Retirement Income
Real Growth rate of Retirement Income
Mortality (age)
Legacy (in todays dollars)
Consumption Growth Rate
The main output is the Current Year Annual Consumption that is feasible given the assumptions.
If you want to contact me at jkspeakes@mac.com I will provide you with this spreadsheet that you can use to calculate sustainable lifetime consumption for your own situation.
