Stages Of Wealth Accumulation

I’ve been thinking about how to describe the various milestones of wealth accumulation. I’m sure others might have differing opinions on the tiers, but here’s what I’m thinking about at the moment:

Stage 1: spend less than you earn

This is basic advice, I know, but this was a major milestone for most of us at some point! At this stage you’re able to save some money. It could be one dollar a year or thousands. The key benchmark at this stage is that you have control of your finances and are able to consistently save some amount of money regularly (weekly, monthly, etc).

Stage 2: Save 10% of your income towards retirement

At this stage you’re finally able to get some serious traction with your saving and investing goals. I think 10% is viewed by most financial advisors (and me) as a minimum retirement savings goal. You age, years to retirement, and expectations will play a large role in whether 10% is “enough” to be saving, but at this stage it’s a great start. Note that this is a 10% gross income contribution by you, and does not include any company match. That would be icing on the cake.

Stage 3: Save a 25-50% of your annual expenses per year.

Now we’re talking. If you can save 25% of your expenses, you are essentially able to take one year off for every four years you work. At 50% you’re clearly able to take 1 year off for every two years you work. This is possible in several different ways. You could have a fantastic income, live a modest lifestyle, or both. And some people may never accomplish this stage, and that’s o.k. It will speed things along if you are to become a hyper-saver (my definition is saving 15% or more of your annual gross income), but it’s not necessary to reach your retirement goals if you have enough time for your investments to grow and compound.

Stage 4: Your investments earn, in an average year, as much as you are able to save.

Now we’ve moved from saving a specific amount to actually generating passive income (or unrealized capital gains). The true target for retirement is a replacement income, so we’re switching our focus from our retirement number (i.e. the amount of investment assets you need to retire) to a passive income goal.

At this point you’re portfolio is growing well and is contributing as much to your annual net worth gains as your current job is. You should continue to save, but at this stage your portfolio contributing more to your retirement goal than your job is. You might hit this point before completing stage three if you’re not currently saving much, but once you hit it after stage three things will really be moving along. If you reach this stage at a early enough age your retirement planning and saving are essentially complete. You can continue to save to speed things along, but you don’t have to, even if invested conservatively, to have sufficient funds available at retirement.

For example, if your portfolio generates 25% of your on-going expenses, then you only need your quadruple your assets (after inflation). This is a twelve to twenty-four year proposition depending on your investment returns and inflation values (7.2% a year return means your assets would quadruple in twenty years, before inflation).

Stage 5: Your portfolio, on average, returns 50% of your annual expenses (after taxes)

If the returns are unrealized capital gains you will need to calculate your after-tax gains to know if they would cover 50% of your annual expenses.

You’re half way to your passive income goal. You’re moving quickly towards your final goal now, and it’s probably seven to twelve years out depending on your investment returns.

Stage 6: Your portfolio, on average, returns 100% of your annual expenses (after taxes)

Congratulations! You’ve reached financial freedom! Your passive income, after taxes, equals your expenses. You might want to build in a buffer and/or continue working, but at this point you don’t have to. It’s your choice.

Stage 7: Your portfolio returns more than 100% of your expenses, even when invested conservatively (as conservative and you deem prudent when you are in retirement), including adjustments for inflation. This is the last stop on the wealth spectrum.

Stage 8: your portfolio earns more than stage 7. Relax, enjoy, and give. (you should be doing these before stage 7 as well…)

Image Credit: Jared Tarbell

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