Sunday, 10 January 2016

What is Retirement?

Some Definitions

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.

The "law of the groceries" means that if you have debts and financial commitments that you can't service from savings or passive income, then you have to work to sustain your lifestyle. This limits your ability to tell your boss what they can do with their job, should you ever be inclined to. Of course, it might be your own business and you are the boss, but you get the idea.

So for me the idea of retirement is inextricably linked with financial independence.

What is Financial Independence?

Let's look at the Wikipedia definition:

Financial independence is generally used to describe the state of having sufficient personal wealth to live, without having to work actively for basic necessities. For financially independent people, their assets generate income that is greater than their expenses.

While we are here, let's define passive income as money which you get from your assets without having to work. There will always be some work involved, for example, you will need to maintain and manage a share portfolio or investment property, but it is not something that you work at 5 days a week (unless you want to).

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. Save more than you spend. Until you get to this point, you have no hope of becoming financially independent.
  2. Use your savings (and debt) to purchase assets which generate cash flow and/or capital growth. 
  3. Keep accumulating assets and reducing debt, until the income from your assets is larger than your expenses.

That's it. But lets put a bit more meat on those bones. Before even step 1 you will need a budget. Yes I know that it is boring to put this together, but it is easier after you have done it once and just need to update it each year. The most important outcome is calculating how much do you need a year to sustain your lifestyle. For us, the number is around $85K (for a couple, no kids and without a mortgage). Obviously everyone's number will be different and dependent on your lifestyle. You should assume that you want to at least maintain your current lifestyle in retirement. No one likes to go backwards. You have to know this annual expense number so that you can work out what assets you need and what sort of yield they need to average.

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!"

My approach is to take a weighted average. Use the actual yields where you know what they are, and use a conservative historical average when you don't. You always underestimate your expenses.

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.

Nevertheless, I take a conservative approach and allow a 3% increase in our spending every year.

With globally low interest rates this is high, but they won't stay low forever (you heard it here first)! Remember - you always underestimate your expenses.

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.

My approach is that you always need somewhere to live, so take the house out of the equation and that can be your emergency reserve or what you bequeath to your relations. To calculate how long your money will last, fire up Excel or your spreadsheet of choice. You need to set four variables:

  • The starting balance - cell B3 in our example (used for the formula below)
  • 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
Once you have this, set up a table with 3 columns (Year, Capital and Income). Income is the amount you spend annually and depending on the numbers you choose, may or may not include some of your capital. In the example shown below, we show that with a starting amount of $1M, a 5% yield and 3% CPI, after 10 years there is $319K of the $1M left. All numbers need to be after tax.

The formula for the Capital and Income columns are as follows:
  • Capital - The first row (2016 in our example - row 9), just equals the starting balance (i.e. =B3). The second row (row 10) has the formula =(B9-C9)*$B$5 + (B9-C9). Where B9 = previous year capital, C9 = previous year income and B5 is the yield. You can then drag this formula down and it will be correct for the rest. Make sure that the yield uses absolute addressing $B$5 not B5.
  • Income - The first row is =85000+$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.
This model is not perfect (by a long shot), for example it assumes that all the money comes out at one time each year. This is not how it usually happens. Regardless, don't get too caught up in perfecting a model based on estimates. This should be close enough and you want to allow some contingency.

You can play with the four variables to model different scenarios.

You can do a similar table for your Super Fund, see below for an explanation of why there needs to be two funds.

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.

The next bit will be country dependent. Based on my birth date, in Australia I can't access my Superannuation funds (equivalent of a 401K in the US) until I am 60. If you retire at 50 but place all your money in a Super fund then you have a problem.

What you need are two passive income generating machines (inside super for post 60 years old and outside super for pre 60 years old). The pre-60 machine needs to last 10 years, so income doesn't have to be all from yield, you can draw down on the capital as long as you can make it to 60. At 60, you transfer the balance to your Super fund. We have a Self Managed Super Fund (SMSF) but it doesn't have to be. I do like the control and ownership that a SMSF brings. Generally speaking, Super is the most tax effective place to grow your savings but the rules do keep on changing so don't put all your eggs in that basket.

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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