Sunday 23 October 2011

Funny Money: Earnings vs Net Worth

Money's a funny thing - the more you look at it, the more elusive the concept of 'money' becomes. Sure, you can pull out banknotes and change, and that is 'money'. But most 'money' is not this 'cash in circulation'; it's numbers on computers. And the way money is created is even stranger - when a bank writes a debt (by lending) it creates money out of thin air. (Which is how we all got into this mess...)

However, to get back to our theme, effective money management means thinking about money in the 'right' way. Effectively, if you have any money (in your pocket, or in the bank) it is basically because you haven't spent it yet. So one way of thinking about money is deferred expenditure.

To bring this home, here is a small, three-stage thought experiment:
  • estimate how much you have earned in your life
  • then estimate your 'net worth'
  • compare the two numbers and draw conclusions

Estimate Your Total Lifetime Earnings

It is usually a surprise to people to realise how much money they have earned.

Your estimate of earnings does not have to be super-accurate. For example, take your employment history in chunks and do an approximate sum of annual income times the number of years employed. Use after-tax income.

In my case, I can 'chunk up' my employment history to (working backwards):
  • 23 years with my last employer
  • 1.5 years a previous employer
  • 2 years overseas (Saudi Arabia)
  • 4 years as a student (I worked part-time but I'm not counting that)
  • 1.5 years overseas (Mauritania)
  • 1.5 years as a junior employee in the shipping industry in London
  • 1.5 years as a trainee overseas (Paris)
  • plus a couple of years travelling

So, about 35 years of paid employment (yes - I'm getting on).

You could work this out on a scrap of paper or a little spreadsheet. Remember, use 'take-home' pay (i.e. after tax).

Calculate Your Net Worth

For this exercise, net worth is composed of saleable assets and the capital value of future income streams:
  • net financial assets (i.e. net of any debt): cash, shares, bonds, etc.
  • net real estate assets (i.e. equity - net of mortgage)
  • pension fund, both 'defined benefit' (i.e. with a defined income guaranteed) or 'defined contribution' (i.e. a fund invested)
  • capitalised value of any other potential income stream (e.g. an annuity): how much capital would be necessary to provide the same income?

For valuing pension rights, the 'defined contribution' is straightforward - it is the current value of the fund (i.e. usually based on stock market quotations). For a 'defined benefit' pension (which is becoming rare) the net value is the equivalent fund that would provide the same income. Usually, the 'transfer value' of the pension would be a good proxy.

For example, my own net worth consists mainly of:
  • family house (fully owned)
  • financial assets
  • 'defined benefit' pension (valued at 'transfer value')
  • 'defined contribution' pension (latest market valuation)

Surplus or Deficit?

Here's the thing, though. If you have worked these numbers out, how do they compare? Do you still own most of your earnings? Or has it all gone? Have you deferred expenditure or not?

In my case my net wealth is around 160% of my total earnings. What we own is worth more than one-and-a-half-times what I have earned. I actually find that amazing. How on earth is this possible, given that for most of the time money was tight?

Well, to some extent I guess I've been lucky:
  • I was employed most of the time, with a company that had a good pension scheme
  • house prices in the UK shot up after we bought our house (but are now slowly drifting down)
  • I made some good share purchases in my employer company (twice)
  • I married a frugal wife

However, I think a lot of the reason is our attitude to money. By deferring spending, the surplus cash has been given the chance to multiply and to increase our future spending power.

So, what is your result - and what conclusions can you draw?

I am not a financial advisor and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.


  1. Good stuff. If people thought about the income streams, current assets, future assets and future asset streams as all simple money flow happening to them - rather than as different things to be dealt with / companies to be paid / benefits to be gifted, they'd go a long way to seeing the bigger picture.

    But they don't, they see them as disparate stages. The means become ends.

    I don't know if I'm being very clear, but anyway I touched on something similar in my post: The One Obvious Thing We Forget When Borrowing Money...

  2. @Monevator Yes - as you point out quite succinctly: when you borrow money you are actually consuming your future income.

  3. About 5 months paid employment for me and total earnings of about £7000.

    And I am 26 soon... I kinda wish I hadn't wasted my youth. Graduate uni the summer after this one. Hopefully I can make up for lost time but I suspect I might end up earning min wage since I haven't got the personality to hack the corporate world.