In marriage, there are three numbers you must know by heart: your spouse’s birthday (October 18), your anniversary (April 19), and how many minutes you can be late before you are in trouble (twelve).
To run a business, there are also three vital numbers you must know: net cash flow, the cost of acquiring a new customer, and that customer’s lifetime value.
It is no different when it comes to financial planning. The three numbers you should know are:
1. Your lifestyle burn rate (LBR)
2. Your start-over-again fund (SOF)
3. Your take-a-hike target (TaH)
If you don’t know these numbers, it is difficult to retire and nearly impossible to feel comfortable about the state of your finances.
And yet, most people go through their lives, striving for financial independence, without any idea of what these numbers are or should be. As a result, financial peace of mind is always around the next corner. (By the way, this is just as true for high earners as it is for working class people.)
Perusing wealth without a specific knowledge of these three numbers is like driving around a city searching for a particular restaurant without any idea of its address.
It doesn’t have to be that way. You can chart a direct path to wealth with these three numbers, and you can do it today. I’ll show you how.
Lifestyle Burn Rate
Your lifestyle burn rate (LBR) is how much you need to spend each year to enjoy the lifestyle you want.
It’s easy to determine this number. Simply calculate how much you are currently spending each year, and then increase that by the yearly cost of all the extra things you’d like to have that you don’t have now. (If you have everything you want, good for you.)
When you do the calculation, group the expenses into five categories: housing (including maintenance and taxes), basic living expenses (i.e., food, clothing, health care, etc.), education (if applicable), entertainment (including travel), and charity (if you believe in it).
This exercise may be illuminating. (When I redid it recently, I was shocked to find how much money I’m spending on cigars $14,000!) You may find that it alters your idea of a quality life. (I’m cutting back to one stogie a day.) It will also make it easier to make adjustments in the future, if your lifestyle changes (see sidebar).
Don’t guess at these numbers. Guessing, in my experience, is synonymous with grossly underestimating. Use your actual costs from the past year. An hour or two with your check register is all the time you’ll need.
Your LBR is a critical number. Without it, you can’t make any other financial planning calculations. Your LBR tells you how much money you need to earn and how much money you can put aside each year for saving and investing.
The Three Stages of Your Financial Life
Your lifestyle burn rate (LBR) is likely to change three times.
The first stage is up until you have your first child. The second stage begins when you have your first child and continues until your children are gone and their college expenses (if you are paying them) are taken care of. The third stage begins after you are free and clear of dependencies, and it continues till you kick off.
For most people, the first stage has the lowest burn rate. You are young and relatively unburdened. If you are wise, you will limit your expenses to necessities and drink cheap wine.
The second stage typically has the highest burn rate. You have larger home expenses, bigger basic living and entertainment expenses, and educational expenses for your children. For some people, this stage may be extended by the need to provide for aging family members.
The third stage has a burn rate that will likely be at least twice that of the first stage, but significantly less than the second stage. This is or can be a wonderful part of your life during which you can enjoy traveling, hobbies, and entertainment without working more than you want to.
To complete this exercise, you’ll need to calculate your LBR for your current stage and any stages you haven’t completed. If you are in stage one, you’ll need to figure out your current LBR and estimate it for the second and third stages as well.
Start Over Again Fund
The next of the three key numbers you need to know is your start-over-again (SOA) fund. This represents the amount of money you would need if for whatever reason you lost all your possessions and all of your savings.
Your SOA number is basically your monthly LBR expenses, multiplied by the number of months you would need to get back on your feet, plus whatever money you might need to start a new business (if you are an entrepreneur or professional).
Most financial planners recommend establishing an emergency fund of three to six months’ living expenses for “emergencies.” I hate that idea because it is arbitrary and vague. Why three to six months? What if you need twelve or eighteen months to get started again? You determine your SOA number based on what you calculate you would really need to start over.
The other reason I hate the emergency fund idea is that almost anything can be considered an emergency: an unexpected dental bill, a broken car axle, a Christmas bonus that was half of what you expected. These events are not true emergencies. They are part of everyone’s financial life. In planning your LBR, you must allow for them. My recommendation is to add 5% to 10% to your LBR. And then, if you are lucky and have no such little emergencies, you can save half of it at the end of the year and spend the other half as a reward for having an emergency-free year.
Your SOA money should sit in its own account, in CDs, or short-term bonds, appreciating for if you are lucky the rest of your life.
“Take a Hike” Number
The third number you need to know by heart is your “Take a Hike” (TaH) number. This is the amount of money you need socked away so that, if you ever want to, you can tell your boss to take a hike.
The TaH number is basically the amount of money you need to retire. I showed you how to calculate this in our October issue. To reiterate briefly: take your LBR, subtract any side-business income you have (and expect to continue to have after you quit your main job), and then multiply that by thirteen.
Why thirteen? Because your TaH money should be held in safe vehicles (such as municipal bonds or rental real estate) that distribute regular income. It’s reasonable to expect a 5% yield from municipal bonds and a 10%-plus return from rental real estate. If your TaH funds are divided fifty-fifty, this will give you an average return of 7.5%. And the inverse of that, in percentage terms, is thirteen.
As an example, say your LBR is $88,000 and you have a side business generating $1,500 a month or $18,000 a year. You’d subtract $18,000 from $88,000 (leaving you $70,000) and then multiply that by thirteen. This would give you a TaH number of $910,000, which would provide you with a tax-free income of $68,250 a year at 7.5%.
Do these three calculations today. Your LBR is first and foremost because it determines, as I said, whether you need to get a better job, add a second income, and adjust your expenses. It will also tell you how many years it will take you to accumulate your SOA and your TaH goals.
A Lesson Learned
In my thirties, I managed to make and save a lot of money without paying much attention to these numbers. But I found out how much they mattered when, at age thirty-nine, I retired and began to live on my savings. It didn’t take me long to realize that my LBR was higher than I had anticipated. It was so high, in fact, that the millions I had saved were sufficient to generate the income I needed to support my desired lifestyle. Shortly after that, I hit a bump that set me back more than a million dollars. I was still a multimillionaire, but I was not financially independent.
I had done so many things right in my career, but I didn’t know my numbers. And because I didn’t know them, I couldn’t retire. I had to go back to work. That was a rude awakening. But it taught me the importance of paying attention to these three numbers.
I remember the day I made the decision to go back to work. I went to bed that night angry with myself, but I woke up the next morning roaring with ambition. Knowing the numbers had somehow inspired me. I was going to do it all again, but intelligently this time. I was going to do it by the numbers.
And that’s what I did. I opened a municipal bond account and funded my SOA goal immediately. Then I opened up a second one (with another broker) and put my remaining money in that account to take care of my TaH goal. Then I created a new, realistic LBR and stuck to it.
These three decisions allowed me to achieve my new TaH target before I turned fifty. I’m quite sure that, had I not paid attention to those numbers, my current LBR would be so high today that I’d still be a slave to my money.
That’s the greatest advantage of determining these three numbers. They will give you a precise knowledge of what you have to do to achieve all your financial goals. More importantly, they will set a fire inside of you that will keep burning until you achieve them.
[Ed. Note: If you're not happy with your financial situation, you're in the perfect position to change it for the better – right now. I've just recorded a special video from my office that covers five profit plays you can use to start growing your wealth. To watch this short video, click here.]