Do you want to retire at 50?

What is Retirement?

I guess we should define what we are talking about. For me, retirement is not about stopping work but about having the freedom of choosing what you work on. To be able to do this you need to be financially independent.

What is Financial Independence?

Let’s look at the Wikipedia definition:

How to become Financially Independent?

This is one of those, easy to explain but hard to do exercises. There are many different routes to financial independence. If you are not born into money, marry into it or created Facebook then most people will need to do something like this.

  1. Use your savings (and debt) to purchase assets which generate cash flow and/or capital growth.
  2. Keep accumulating assets and reducing debt, until the income from your assets is larger than your expenses.

How Long will I Live?

This is a bit of a morbid question but it is an essential variable in our financial independence calculations. The only way you don’t need to have a guess at this is if your asset pool is big enough to fund your lifestyle without drawing down on the capital.

What Yield can I expect from my Assets?

This is either a very easy question (e.g. whatever the interest rate is on your bank savings or term deposit) or it is a guess, albeit probably based on historical yields. Shares and their derivatives fall into this second category. The long term yield of the share market may be over 7%, but unless you have an index fund, your shares aren’t the market. Also, people don’t feel averages, they feel the ups and downs (particularly the downs). Last year the share market in Australia dropped. If you are banking on 7% growth, then you have to eat into your capital to fund your expenses, which means future yields need to be higher than average. Of course some years will be above average and you will think that you are a share market guru. This makes forecasting hard. All you can do is have a go and adjust the plan as circumstances change. Like Mike Tyson says, “Everyone has a plan until they get punched in the face!”

How much will my Expenses grow each Year?

At a certain point your expenses will stop growing and start to shrink. Even with CPI increases and the best will in the world, as you get old you slow down and don’t do as much. The silver lining to this is that you wont spend as much money. The one area that doesn’t decrease is the amount you spend on health. This skyrockets and this is where all that health insurance that you have been paying starts to provide a return.

How much money do I need to Retire?

You will see a lot of people suggest that the answer is 20 times your annual expenses. So if this was $85k, you need $1.7M in assets. This could be your house but you would need something like a reverse mortgage to have cash to live on. There are some pretty big assumptions in the 20 times number, it assumes you (and your partner and dependents) will live for another 20 years and it assumes that the yield on your assets is the same as CPI. I think we can be a bit more scientific than this.

  • The annual draw down amount (e.g. $85k) — cell B4
  • Estimated Yield on your assets (i.e. the starting balance) — cell B5
  • Estimated CPI — cell B6
  • Income — The first row is =85000+$B$6*85000 (i.e. $85k + CPI). The second row (row 10) has the formula =C9+$B$6*C9 (i.e. compounding CPI). You can then drag this formula down and it will be correct for the rest. Make sure that CPI uses absolute addressing $B$6 not B6.

The Financial Independence Model

To help visualise what financial independence looks like, I use the following model. The goal is to get your active income to zero. To do this, your passive income needs to equal your annual expenses. Any income overflow greater than $85k (in this example) goes back in the investment pot. This will happen if your yield is higher than expected or your capital pot is bigger than required. Don’t be tempted to spend the overflow in good years, there will be bad years.

One more thing — Tax Minimisation

I’m not licensed to tell anyone about anything, so my advice is to go see someone who is. Find yourself a good accountant that you trust. They can save you a lot of money. We all need to pay tax and that is usually a sign that you are making money (which is good!), but no-one should be paying more than their fair share. Play within the rules but find out the rules so that you can maximise the outcome for you. Ideally, you need to do this before you start accumulating assets, but it is never too late to learn more about tax effective strategies. This is an area which will have a material effect on how long it takes to reach your goals.

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