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The run up to Financial Independence (part 3)

Part 3 of the run up to financial independence: How I classify my income and expenses. Plus how to avoid common gotchas and traps for young players.
To me Financial Independence is about cash flow. Possessing one or more regularly recurring income streams can make you feel financially free. The absence of one most definitely has the opposite effect!

Income

I classify my income into two categories.

Passive Income – Money that I get paid regardless of what I’m doing, whether that be lazing on an Australian beach, drinking beer in the sunshine with my mates at the cricket, or while writing this blog post. Examples include dividends, interest, rent, royalties and realised capital gains.

Earned Income – Money that I only receive if I actually turn up and do something successfully. Deliver a project, write a paper, herd cats and shout at people. Examples include billable hours, bonuses, commissions, employer pension contributions, and salaries.

I would include things like gardening leave, maternity leave, study leave, paid holidays, sick leave, redundancy payments and so on in the “earned” income category because in order to have qualified for any of them I would first have needed to work for an employer who presumably hired me to actually do something in return for my pay packet!

 My rule of thumb is if something isn’t causing your bank balance to increase then it isn’t income.

My rule of thumb is if something isn’t causing your bank balance to increase then it isn’t income.

Therefore unrealised capital gains are not income. They remain a figment of your imagination until such time as you actually sell the appreciating asset. This isn’t a big deal for me as I generally don’t like selling income producing assets. Your mileage may vary.

One important thing to note is that passive income will not make you rich. Capital gains may.

Passive income will not make you rich. Capital gains may
If escaping the rat race was going to be a sustainable option then the important figure of the two is the Passive Income.

Expenses

My spending breaks down into five categories.

Needs – nothing but the essentials (excluding housing). Examples include utilities, groceries and medical care.

Housing – the cost of my accommodation. This includes not just rental expenses / the interest component of mortgage payments, but also maintenance costs, property taxes, home & contents insurance, and other housing related expenses.

Taxes – these are expenses like any other, and as such need to be tracked, managed and minimised accordingly. Examples include income tax, capital gains tax and withholding tax.

Investment Expenses – the costs associated with establishing and maintaining those income producing assets. Examples include brokerage, estate agent commissions, and investment platform fees.

Wants – everything else, including feeding my wife’s expensive shoe and handbag habit (despite her protestations these are actually needs).

My spending breaks down into five categories.

To be useful the Needs versus Wants assessment must to be brutally honest. The approach I have adopted is that any expense on the bottom level of Maslow’s hierarchy of needs is a need, everything else is a want... including take away dinners, Lindt orange chocolate and alcohol even if they arrive in the grocery delivery!

Classifying is easy, now for the analysis!

If your investment expenses are greater than your passive income then you are doomed! Either you were dropped on your head as a small child, or you are an idealistic dreamer. Either way you need to give yourself a firm slap to your lower extremities and start plotting an exit strategy.

To avoid compromising your lifestyle investments must be self supporting. If they are not then you end up subsidising them out of your earned income, which is not a sustainable approach if you are at all inclined to jump off the hamster wheel of paid employment.

investments must be self supporting

That general principle said, I am a pragmatist at heart. I fully recognise that some investments (particularly real estate) are opportunistic, purchasing while the price is low with the intent to capitalise when the price is high. Perhaps there is a planning submission for a new shopping centre nearby, or the government has announced a massive public transport upgrade that will see a new tube/train/bus station placed nearby.

Therefore my rule of thumb is that the investment portfolio in aggregate must be self funding, which means some positive cash flowing investments may subsidise strategic acquisitions that are set for a massive capital gain. Again, be brutally honest with yourself here... wishful thinking is not a winning investment strategy!

wishful thinking is not a winning investment strategy!

Financial Independence

You are not financially independent until your recurring passive income streams cover your needs + housing + investment expenses.

Once you cross this threshold by all means do the victory dance and feel good about yourself for a second or two. Then pull your head in, because the quality of life you will exist on at this point sucks.

Back in our university days many of us subsisted on a diet of beer and two minute noodles. However once we turned 27 we started to wear our beer, and realised that there is a reason that living like a student has an expiry date.

Where you live has a huge impact on when you achieve Financial Independence

The housing expense is worth spending some time considering, as after taxes this is likely to be your single biggest expense. For most people it is their choice of living location that determines how financially free they are. You could be happily living in Laos on USD$7 a day... but you would be living in Laos, not in Kensington or Boston or Bondi.

Where you live has a huge impact on when you achieve Financial Independence

The key point here is choice. You are choosing to live where you live. Own that decision. Either make your peace with it or do something about it. Nobody likes a martyr or a victim, either move or stop complaining about how expensive it is!

Financial Freedom

You are not financially free until your recurring passive income streams cover all of your needs + housing costs + investment expenses + wants.

At this point your lifestyle is sustainable from your investment income alone. Congratulations, you have beaten the system and won the game of life. You now have the luxury of choice, and from this point forward it is your own fault if you are miserable.

Working becomes optional.

From this point onwards if you hate your job or your boss or your co-workers then do something about it. You have the luxury of choice, so either exercise it or shut up.

Not so fast, you've not mentioned taxes

Note that I haven’t included taxes in the assessment of Financial Independence or Financial Freedom. This is because paying taxes is largely optional, determined by your choices.

If you choose tax advantaged investment vehicles like ISAs or ROTH IRAs then you don’t need to worry about taxes, you have already paid them. Sorry all you Australians, you guys don’t get to play in this space, this kind of account doesn’t exist in Oz.

If you choose tax advantaged investment vehicles like SIPPS or 401k plans then you’ll have to suck up any taxes you incur when you draw down money from these accounts. Conventional wisdom is your income in retirement will drop below the punitive tax brackets… which depending on your housing costs and outgoings may or may not provide you with some consolation.

If you choose taxable accounts then you probably need to talk to a professional tax advisor or financial planner. Society demands that you should contribute some tax, but how much largely depends on the quality of the advice you receive combined with your tolerance for risk.

All retirements are not created equal

If you’re planning to retire earlier than is conventional then you need to plan carefully. Money locked away in pensions is great for funding your dotage, subject to running the not insignificant risk that the government will change the rules between now and when you plan on accessing it.

However if you’re planning to escape the rat race earlier then you will likely need access to funds outside of tax advantaged pension wrappers. The earlier you escape then greater the amount of funds you will need to be able to access.

How much is enough?

I’m old enough to remember standard variable mortgage rates of 18%, and watching my grandparents put in place plans to fund their retirement solely from term deposit interest payments. They did it really hard when interest rates plummeted to what we currently consider to be “normal” today.

I’m old enough to remember inflation rates of 15%, which made anyone focussing on a fixed amount of income feel poor very quickly.

I experienced what it was like trying to get a job without any marketable skills when unemployment rates were over 30%. This would be comparable to somebody attempting to get a job 5-10 years after declaring early retirement. Good luck with that.

I have experienced the disappointment of setting a net worth target of the seemingly astronomical amount of $1,000,000 only to attain it and realise it doesn’t even come close to funding a sustainable retirement.

The average UK annual before tax earnings is around £27,000... which is far from a comfortable standard of living, particularly in London. Achieving this by applying Big ERN’s 3.5% “safe” withdrawal rate would require a net worth of around £771,500.

To earn that same amount while living within the “yield shield” would require a net worth of at least £1,350,000 based on current market dividend yields.

I’m not a big believer of selling off passive income producing assets to fund retirement living expenses, as if you retire at 40 may that means your capital base must be able to sustain you for another 60-75 years... you never know, you might be one of those 115 year olds being interviewed by the Guinness World Records people. Good luck with that if you start selling down your capital to pay for your living costs in year 1!

How much is enough?

Reality check

Now for a reality check. Hardly anybody can afford to live in London on average earnings. Many of the private schools charge around that much per year per student for tuition, nursery fees aren't significantly less. In my neighbourhood you couldn't rent a cardboard box in the park for the average UK wage.

Which brings us back to the choice of living location question. Life is about choices. After the choice of spouse, living location is probably the single most financially significant decision you will make.

It influences what your financial baseline looks like.

It determines who you see as your (and your children's) peers and friends. This in turn heavily influences what you (and they) consider to be "normal".

Choose wisely, or forever feel poorer than you need to!

So what?

This post outlines how I keep score on where I am at financially, and how well I am doing.

Personally I find reading about other people's net worth or income statements on the internet to be singularly unhelpful.

Everyone leads different lives, with different priorities, in different cost of living locations.

Rather than measuring yourself against some (most likely made up) figures off the internet, compare instead yourself today to yourself last month or last year. The basis for measurement and comparison will at least be consistent, and your values are unlikely to have changed materially in between.

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