Each time I publish a portfolio update, there is often a small amount of confusion in the comments.
You might have noticed this too.
The question goes: “How are you able to be ‘retired’ if your passive income from investments is less than your spending?”
“Doesn’t this mean you’re forced to work, and therefore, are not financially independent at all?”
This thinking makes perfect sense. But it’s also easily explained (well, kind of!), even though it’s not intuitive at first.
Since the question comes up repeatedly, today I’ll share how our finances work on a month-to-month basis. Rather than point out other places I’ve mentioned it in passing, future commenters can be directed straight to this post.
Our situation and overall strategy
Regular readers will know we hit Financial Independence in 2017 with most of our savings in property, along with some shares.
The shares provide a convenient income stream, but because of mortgage debt, the properties do not. In fact, they actually cost us money because we’re now paying P&I on each loan.
The big picture plan is to convert our savings into a 100% share portfolio. This will give us a simple portfolio and a convenient passive income stream. To do this, we’re slowly selling off properties (every few years) and investing the proceeds into shares.
Why we’re doing it this way
Some say we should just offload all the properties immediately. But we’re choosing the slow and steady transition rather than a ‘rip-the-band-aid-off’ approach for a few reasons.
— It’s a much lower stress way to transition. I wouldn’t like to be selling multiple assets at once, or even one after another and then having to invest large lumps of cash in one hit.
— The tax on our capital gains would have been much higher if we sold multiple properties in the same year. (this is no longer a problem as we’ve already sold the assets with the most gains)
— We wanted more flexibility over when to sell. Obviously, market conditions are rarely good in all markets at the same time. So, if the local property market is weak, we can try to wait a bit longer before selling the next one.
— We wanted to dollar cost average into shares over time. This has allowed us to keep investing regularly while learning at the same time. Plus, this helps avoid regret, because the effect of averaging out of one asset class and into another should smooth things out and reduce the chance of a really crappy outcome.
What this looks like in practice
After selling a property, we end up with a large lump of cash. We put this in an offset account. Any rental income, dividends and part-time work income we get rolls into this bank account too.
From here, it’s a big bucket we use each month to pay for everything. Living expenses, investment mortgages, as well as using a small amount to add to our share portfolio.
Mainly because of our P&I investment mortgages, this cash balance declines over time. I try to make sure each property sale creates enough cash to last 2-3 years. At that point, if we haven’t already, it’s time to sell another property and continue the process.
Over time, we end up with less property and more shares, eventually resulting in a 100% share portfolio which should create passive income higher than our spending.
So that’s how it works, even though it probably sounds strange to many people. In fact, I’ve not heard of anyone doing this before, but I’m sure someone has!
Look, I wish I had a clean and simple situation to share with you. But I just don’t. That’s the way it is. The other ‘transition’ scenarios I considered before leaving work were much less appealing than this one (most involved working longer, paying lots of CGT, or trying to take on more debt).
Concerns and possible problems
Now, I know some people will be thinking, “but you’re selling assets to live on, that can’t be sustainable.”
You can think of it like someone living off the proceeds from selling a portion of their share portfolio over time. This is perfectly sustainable, barring disaster. The difference is, we’re doing it with property, while reinvesting some cash into shares.
Unless property and shares both turn to shit for an extended period, this should work out okay. If our properties struggle (and in recent years they have), we simply end up with less cash from each sale, and less to put into shares.
That doesn’t sound great, does it? But let’s think it through. From our current situation, what does a bad outcome from here look like?
Let’s say we get zero dollars from the rest of our properties. We simply sell them off, the debt disappears, and we’re left with our current cash balance and shares.
We’d then invest our cash balance, so that would probably put our investment income at somewhere around $30,000. If our spending is $40,000, that’s not too bad. So, we’d end up being 75% retired. Hardly a terrible outcome.
And if you include the fact that we’re both happily earning some part-time income already, we’d actually still be able to invest each month and grow our portfolio from there. I definitely wouldn’t go back to full-time work just for the formality of being 100% FI as soon as possible.
At this point, I’m enjoying freedom so much that it simply wouldn’t be worth it. Especially considering what I’m doing doesn’t really feel like work and I would continue to do it regardless of how our investments turn out.
Honestly, if things get that bad, we’d likely choose to wait longer before selling properties, and maybe use our part-time income to keep paying the mortgages until things picked up.
We’re also flexible with our spending and have a growing amount of super which will eventually be accessible (much sooner for Mrs SMA than myself).
Here’s something I think people forget: If someone starts with 25 times their annual spending saved up (the typical recommendation), this cash will still last 25 years even if they don’t invest. Of course there’s inflation, but earning 1-2% in a savings account would cover that.
Sequence of returns
Consider someone living on an all-share portfolio who runs into a nasty patch of returns just after leaving work. The market collapses and dividends dry up.
What would they do? They’d simply pull one of their backup plan levers: use their cash or bonds, spend less, earn more, and so on. But they could also continue to spend down their assets if other backups will plug the gap later, like super or the pension.
There is no perfect and permanent plan. In the real world, shit happens and you have to be flexible. That’s just part of the deal when living off investments.
If you don’t like the sound of that, simply keep working. Either forever, or until you’ve amassed a ridiculously huge amount of investments. Either way, you’re trading away freedom now for security in the future.
Behind all the numbers here, I always try to stress the importance of being a resilient and adaptable person. Because that’s what makes all this work. And that’s what gives you confidence that whatever happens, you’ll adapt and continue to lead a happy life.
Hopefully this article offers a good overview and clears up the confusion around how we manage our money each month. It’s unusual and not ideal, but it works for our situation.
It’s entirely possible that our plan doesn’t work out as well as… um, planned. But so what? By the time we’ve offloaded the last of our properties, we would’ve been doing our own thing and enjoying life for more than a decade!
And like I said, even a bad outcome from here results in eventually being slightly less than 100% FI, with zero change to our current life.
I guess we’ll deal with that particular tragedy if and when it happens 😉 But until then, freedom is the driving force in what we do, not fear.