Academic journal article Financial Services Review

Factors Related to Meeting the Capital Accumulation Ratio Guideline

Academic journal article Financial Services Review

Factors Related to Meeting the Capital Accumulation Ratio Guideline

Article excerpt

Abstract

The capital accumulation ratio, investment assets divided by net worth, has been proposed as a useful indicator of financial health. Various experts recommend a minimum value of 25% to 50% for the ratio. When certificates of deposit are not counted as investment assets, 56% of U.S. households meet the 25% guideline and only 40% meet the 50% guideline. In a multivariate logistic regression, education, income, number of years until retirement, overspending, and financial risk tolerance are positively related to meeting the guidelines. © 2002 Academy of Financial Services. All rights reserved.

JEL Classification: D9; G29

Keywords: Capital accumulation ratio; Financial ratios; Retirement adequacy

1. Introduction

Financial ratios can provide a convenient way to diagnose the financial status of households (Greninger et al., 1996). Financial ratios provide numerical objective yardsticks designed to help simplify the judgmental assessments of current financial strength and changes over time (Garman & Forgue, 2000). Ratios are a type of quantitative tool used in decision-making. Typically, ratios can be quickly calculated and easily interpreted. They can help clarify and simplify financial analysis. They should be applicable to most households. The study of financial ratios offers potential for increasing insight into specific strengths and weaknesses of a family's financial situation (Prather, 1990). One household financial ratio that is somewhat related to the issue of retirement adequacy is the capital accumulation ratio (CAR). DeVaney (1995) suggests that if the capital accumulation of a household is at least 25% of household net worth, the household might be on track for being adequately prepared for retirement.

This paper studies the financial health of households in terms of the CAR, because the accumulated capital is an important retirement resource. The CAR is defined as the ratio of investment assets to net worth. It reveals how well a household is achieving its financial goals for wealth accumulation (Garman & Forgue, 2000). The basic idea of this ratio is that a household should have a substantial part of net worth in assets that will grow, in order to provide for future goals such as retirement. Some experts recommend that this ratio be 25% or higher (Lytton, Garman & Porter, 1991; DeVaney, 1993). Based on surveys of financial planners and educators, Greninger et al. (1996) conclude that the median minimum value recommended is 50%. DeVaney (1995) suggests that meeting the CAR guideline is a good indicator of whether a household is on track to achieving an adequate retirement. This study examines both levels of the CAR guideline, and factors related to whether households meet the guidelines.

2. Literature review

Empirical research on household financial ratios has been limited. The few previous studies with a focus on households and the CAR (Lytton et al., 1991; DeVaney, 1993, 1994, 1995) use 25% as the guideline for the CAR. Greninger et al. (1996) suggest the need for a CAR of at least 50%. All of the guidelines suggested in previous studies lack a theoretical basis. They are developed from intuitive rules of thumb rather than theory or empirical findings. In the following paragraphs, general studies of ratios are reviewed and then studies specifically focused on the CAR guidelines are reviewed.

Lytton et al. (1991) use a hypothetical case study and suggest nine financial ratios that could be broadly applied and interpreted by financial counselors and planners as well as individuals and families. They recommend that the investment assets-to-net worth ratio (i.e., the CAR) be at least 25%. The authors suggest that this ratio is usually less than 20% for young people and that as they advance through the life cycle toward retirement, this ratio should increase.

The Lytton et al. (1991) guideline is based on the authors' intuition. …

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