Net wealth expands on the concept of net worth by taking into account human capital and the present value of future consumption needs. In other words, net wealth is the present value of all available marketable and non-marketable assets less the present value of all current and implied liabilities. Net wealth is the amount that is reported on the economic balance sheet, the formula is as follows:

Let’s assume that an individual had the following assets on his traditional balance sheet:

Based on this traditional balance sheet, this individual has $2,882,000 in traditional balance sheet assets. On the economic balance sheet, all of these entries would be consolidated into a single asset referred to as financial capital. From there, human capital and the present value of any pension assets would be added to financial capital in order to find the total dollar value of assets on the economic balance sheet.

Let’s assume that based on this individual’s profession, his human capital has a present value of $7,500,000 and the present value of future pension benefits is $500,000:

Based on those assumptions, total assets on the economic balance sheet would amount to $10,882,000 compared to $2,882,000 in total traditional balance sheet assets.

Let’s also assume that this individual had the following liabilities on his traditional balance sheet:

Based on the traditional balance sheet, this individual’s net worth would be $2,882,000 – $525,000 = $2,342,000. Now, let’s calculate and compare the difference between net worth and net wealth.

On the economic balance sheet, the total dollar value of liabilities would be entered on the economic balance sheet as a single entry referred to as debt. In addition to debt, the economic balance sheet takes into account the present value of all future consumption needs.

Let’s assume that the present value of lifetime consumption needs amounts to $5,200,000, based on this individual’s lifestyle:

Based on these assumptions, economic balance sheet assets amount to $5,740,000 compared to $540,000 in traditional balance sheet liabilities.

Given the numbers above, we can now calculate this individual’s net wealth, which amounts to $10,882,000 in economic balance sheet assets minus $5,740,000 in economic balance sheet liabilities, for a total net wealth of $5,142,000.

In short, give the assumptions above:

net worth = $2,342,000
net wealth = $5,142,000

Conceptually, two individuals could have the same exact net worth, but their economic net wealth could be vastly different after factoring in income potential and lifestyle needs. In essence, the difference in total net wealth between two individuals with identical net worth may result in different investment strategies, and tolerances and attitudes towards risk.

The Excel file used to calculate net worth and net wealth can be found here.

The formula used to calculate an individual’s human capital is as follows:

Where:

Depending on the profession, the wages used may be higher or lower and more or less sensitive to the business cycle. Additionally, the discount rates used in the model should be consistent with the risks of wage growth and consistency of the assumed profession.

Let’s assume an individual was 55 and planned on retiring when he or she reached the normal retirement age of 65. Further, this individual’s current salary is $100,000 and as a professor has consistently received a 3% cost-of-living adjustment (COLA) on an annual basis.

Since this individual has tenure, the discount rate assigned for occupational income volatility is 3%, and the risk free rate is currently 2%. What is the present value of human capital for this individual if he or she has an expected survival rate of 99% in the first year, declining at 1% thereafter on an annual basis?

First, let’s use Excel to model the future value of wage growth over the next ten years at a 3% annual COLA:

Next, we’ll need to discount the future value of wages in each year to the present period by the total discount rate, composed of the risk free rate and the discount rate assigned to occupational income volatility:

Using the total discount rate of 5%, we can expand the table above as follows:

Now, we will multiply the present value of wages in each year by the expected probability of survival in each given year:

Multiplying the present value of wages by the probability of survival in each year, yields the product which represents the probability weighted present value of wages. The summation of each of these values indicates this individual’s human capital is $852,875.90 under the given assumptions.

In other words, if this individual were to pass away today and had dependents who were counting on this income for survival, a total of $852,875.90 of life insurance would be required to replace his income if no life insurance policies were currently in force.

Keep this formula and model in mind the next time an insurance agent tries to randomly assign an arbitrary face amount to a policy when attempting to sell you life insurance.

A copy of the Excel model used to calculate the present value of human capital can be found here.