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Finding the Upside on Your Household Balance Sheet – The Financial Preserve from Lonier Financial Advisory LLC
Conscientious Financial Planning and Retirement Income Management | 201-741-9528
from Lonier Financial Advisory LLC, Osprey, FL

Finding the Upside on Your Household Balance Sheet

Finding the Upside on Your Household Balance Sheet

Inescapably the time comes to consider that spending from savings is different from saving from income. You survey your savings and investments, scattered across a number of accounts, and the question arises, how best to manage this money to get the best lifetime outcome for the household when you are no longer earning a high income from full-time employment?

Maybe you’re thinking about rolling over 20 or 30 years of 401(k) contributions made to an assortment of funds almost randomly picked over the years, or are holding mostly cash after exiting the market during the 2008 crisis and now realize your money needs to work harder.

How do you organize—allocate—your savings and investments? How much should you invest in stocks and bonds and keep in cash? How do you decide what is best for you?

The Answer to the Puzzle is More Puzzles
You can go with rules of the thumb, like the old chestnut “age in bonds,” possibly with +/- some number adding a veneer of math to what is essentially an arbitrary amount. You can put your money in a target date fund and pay a fund company .20% to 1.00% to use their proprietary “glide path,” which adds a costly layer of research to the age in bonds formula. (Hint: Index TDFs are cheaper.) Dig deep enough, and your head might spin over how highly researched glide paths can be so different.

You can ask an investment advisor who will give you a short quiz and categorize you as conservative, moderately conservative, moderate, moderately aggressive, or aggressive, and plug you into a model portfolio that has somehow been matched with these categories which have somehow been matched to the quiz answers you gave. If that doesn’t seem right, there are advisors who will give you a longer quiz, or more categories, like south-by-south-west, or both. And whichever direction you turn, you’ll pay maybe 1.00% a year.

Everyone has an answer to your puzzle. It’s just that they’re different answers.

If you want to figure it out yourself, you are encouraged by most experts to think deeply about your risk tolerance, how you are likely to react when the bottom falls out, how much you can afford to lose (none!), and then pick a number between 0% and 100% for stocks based on…your best guess.

Look Beyond Your Investments to Your Balance Sheet
Your savings and investments are just one part of the puzzle, one part of the resources you need to manage to get the best outcome. You need to start at a place that accounts for all of your resources, that balances what you have and what you need, revealing the weaknesses—the risk exposures—you need to overcome. Financially, the place to start is with your household balance sheet.

You are probably familiar with a simple net worth statement that sums up current financial assets and debts and provides a snapshot of solvency. A full household balance sheet for planning goes further than that. The asset side of the balance sheet includes the current value of savings and investments (financial capital), the discounted present value of expected future earnings (human capital), and the discounted present value of expected Social Security benefits and pensions (social capital). The liability side includes the discounted present value of all expected future expenses, including debt service and payoffs.

I won’t cover the details of how to calculate these present values in this post, but though it sounds intensely complicated, it’s not. It’s within the reach of anyone familiar with using Excel, and is no more involved than examining your conscious for risk and divining an asset allocation from an arbitrary formula. More importantly, it represents your specific household situation in a logical and mathematical fashion without making any leaps of faith about theoretical risk, personal inclinations, or market behavior. More math, less magic.

Let’s look at a household balance sheet constructed in this way (below). What does it tell us?


The assets on the left include $1,824,700 of financial capital (FC), which is the current value of the household savings and investments in retirement and taxable accounts. The relatively low $274,800 of human capital (HC) suggests in this instance a household nearing retirement with just a couple years of earnings remaining. Someone with ten or fifteen years of employment ahead of them might have human capital over a million dollars. Not surprisingly, the $1,977,000 present value of social capital (SC)—Social Security and pension benefits over a 30-year retirement plan—is the most valuable asset on this particular household balance sheet.

On the liability side, the present value of all expected future expenses over the life if the plan (about 33 years in this case) is shown as $3,381,400. Subtracting liabilities from assets, the balance sheet shows a cushion or surplus of $695,200.

The financial lifecycle is the process of converting human capital into a stream of income that covers ongoing current expenses while building FC and SC to cover future expenses when HC has been “spent down” going into retirement. The balance sheet shows the current relationships between savings and investments, expected future earnings, accrued social capital benefits, and expected future expenses, all either in current or discounted to current dollars. It is the definitive household financial lifecycle scorecard, and so is enormously useful in answering the question about how best to allocate household resources.

Some simple math allows us to focus on the puzzle of puzzles, the allocation of financial capital (below).


If we subtract the sum of HC and SC ($2,251,900) from liabilities ($3,381,400), we are left with $1,129,400, the amount of expenses that must be covered from savings and investments (from FC). We can call this amount ($1,129,400) the income floor, the minimum amount of FC needed to cover expected expenses. Note that the cushion of $695,200 from the balance sheet is the amount of FC above the floor (FC of 1,824,700 minus floor of 1,129,400 = 695,200 cushion). This represents, after holding back some amount for reserves, the risk capacity indicated by the balance sheet, or more simply, the upside. In this case, after holding back a reserve of $125,100 from the cushion of $695,200, the resulting upside is $570,100.

The final step is to lay this out as an allocation of financial capital, based solely on the strength of the household balance sheet (below).


Using the amounts above, the balance sheet shows an Upside/Floor/Longevity/Reserves allocation of 31.2%/61.9%/0%/6.9% (Longevity is a discussion for another day, but it generally starts with funding the deferral of SS benefits as the best deal around). Note that although this shows how much of FC can be exposed to upside risk and how much should be managed as floor, it is agnostic about how that should be done. In fact, as shown above under the “Adjusted” allocation, once you know what your balance sheet says, you can make an informed decision to expose more floor or less upside to risk, as you determine works best for you. In this case, about 9% of the floor has been allocated to upside (increasing the balance sheet upside allocation from 31.2% to an adjusted 40%), putting that much of the floor at risk—and therefore requiring careful management to prevent market losses from damaging the ability of the floor to cover expenses.

The Foundation for Solving the Puzzle
There is a misapprehension that using balance sheet risk management to allocate financial capital is somehow insurance product centric, puts safety-first above all, or is just liability matching in a different costume. It can be used to allocate any of those things, just as it can also be used to allocate a total return portfolio, a dedicated floor with upside, a bucket system, or a combination of upside portfolio, bond ladder, and insured products. All of those things are about implementation, and are independent of the mathematical determination of how much household FC should be managed as upside, floor, longevity, and held for reserve.

Balance sheet analysis comes before implementation. It replaces the narrow view of the investment portfolio and total-return allocation theories as the central focus of retirement with a broader understanding of the overall household financial situation and managing all the risks that can affect the retirement plan, not just investment risk.

The household balance sheet, not portfolio theory, is the foundation of personal financial management, anywhere in the lifecycle. A solid understanding of the household balance sheet provides the basis for a reasonable and practical way to solve the puzzle of how to best use household resources to fund retirement or reach other goals.

This is a brief introduction to a subject with a deep body of knowledge that is typically not part of an investment advisor’s agenda. For further study, check the reading list at the Retirement Income Industry Association website for links to additional readings and sources.

If you’d like more information about goals-based planning and lifecycle savings and investing from the household balance sheet, please feel free to contact me at mlonier@lonierfinancial.com.

Michael Lonier, RMA®

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