July 14, 2017
Today, it’s personal!
The time has come for a bit of nitty gritty numbers on how people can earn and save their way to financial independence.
We’ll look roughly at our own journey in numbers, and how the numbers really work for early retirement and Shares.
Not that long ago, I was suggesting that compounding is king.
Today I’m going to argue with myself and tell you it’s not that much of a factor with an early retirement time-frame of less than 10 years. This is because compounding needs quite a while to really get going.
Retiring freakishly early is much, much more about saving than compounding!
Before we start I will just acknowledge, these numbers are rough guesses and averages at best.
I don’t have the details on every year’s pay and expenses. I just keep a running estimate of everything in my head. OK, some is on paper, but not much.
I’m definitely not a spreadsheet junkie by any means. To tell you the truth, I didn’t even know how to setup a spreadsheet, until last year. We don’t even track a budget!
I won’t lie. We had it good. We earned pretty good wages on our journey to Financial Independence, around 75k each before tax, in our final year of employment.
Not low, but certainly not excessive by any means. Actually, it’s right around the Median Full Time Australian Wage according to the ABS.
Although I put in a fair bit of overtime over my 10 year career, my wage still never reached six-figures.
Our combined household take-home pay averaged 150k, or around 115k after tax. In the earlier years, our wages were lower, but I did lots of overtime, so it averaged out to approximately this.
With our living expenses averaging around 45k, we managed to save around 60% of our pay over the years.
Saving 70k per year sounds impossible to most people. But, this was due to living comfortably within our means, and not allowing our dual incomes to inflate our lifestyle exponentially, as is the norm.
It’s not hard, it’s just different.
Funnily enough, I was originally planning on being financially independent in my early-mid 30’s solely through property, using some form of living off equity strategy to retire.
I feel so lucky for learning about how incredible the dividend income from shares can be. It really pulled forward our retirement date. Also, it’s a much more reliable and sustainable form of retirement income.
Many people can achieve this, but after all the excuses are thrown out, the truth is they just don’t even try.
It’s a bit under 900 bucks a week. $450 for rent/mortgage and $450 for everything else. That seems pretty reasonable to me. There’s even plenty in our spending that is optional, but we’re happy where it is.
To be clear though, it definitely didn’t happen by accident. Here are the juicy details of our household spending down to the last dollar.
Along the way, I analysed where all our cash went and optimised every single category of spending. We focused on living simply and happily. Over the years, our spending just got lower and lower.
We both knew of a few people at our workplaces, on the same, or quite often higher wages than us.
These people could only just pay their bills. It’s no coincidence they were either constantly buying a new car on finance or constantly renovating their house (yes, apparently some people need to keep modifying their house, I don’t get it?), in between their expensive holidays and phone upgrades.
Novelty is the new normal it seems. I wrote about this crazy phenomenon recently here.
Let’s take a look here, at a grossly oversimplified version of how we were able to retire in less than 10 years by saving and investing around 60% of our pay.
As you can see, most of the end balance actually comes from cash saved, not from investment returns.
This is due to the short time-frame of our financial independence journey.
Compounding is awesome, but saving is awesome-er!
This Early Retirement Calculator is the best one I have found. I’ve used it a fair bit, to make many different projections. If I’ve done it correctly, it should even have the numbers from our own scenario plugged in already!
So you know, I have changed the ‘withdrawal rate’ to 6%, to account for the 6% dividend income generated by our portfolio of LICs/Shares to live on. This is just looking at an estimate of the income from our Aussie shares including franking credits.
In reality, we’re also going to keep a cash buffer for times when dividends are reduced, during a recession.
Have a play around with it to suit your own situation and see what you come up with by tweaking your savings rate 🙂
FYI, it makes a massive difference, and you can see immediately how lowering your expenses literally shaves years off your prison sentence!
Change the ‘withdrawal rate’ to 5%, to see how much you need you might need in total, including a cash buffer.
In this chart above and the early retirement calculator website, the savings are invested and compounding at 5% after tax and inflation.
This fits with what I think is a fair assessment of the likely return from Australian shares while you’re still working. To break it down…
Gross dividend (including franking credits) of 6%, plus growth of 3% = 9% total return. Less tax 2%, less inflation 2% = 5% after tax and inflation.
You could even work on a lower investment return. It wouldn’t change the end balance too much, because most of the end balance comes from savings, remember?
When making future early retirement calculations, it makes sense to account for inflation.
Although, once we reach retirement, we’re then dealing with the present time, so we only need to be concerned with any taxes we need to pay and whether our dividend income will continue to grow with inflation.
As the chart/calculator reaches the end of Year 9, the balance is around 800k.
This pool of equity in Aussie Shares will still be providing around 6% in dividends (including franking), which is 48k per year. This is pure cashflow you can live off, never having to sell down your assets.
You’ll need a cash buffer too, which I’ll get to in a minute.
You may still need to pay some tax too, depending on which tax bracket the income falls in…
But according to this income tax calculator, a couple can earn 41k of income (20.5k each) in retirement and pay precisely ZERO in tax, due to the tax-free thresholds and some other tax breaks for low income earners.
So, although it may suck paying a bit of tax along the way, I wouldn’t worry about tax too much in retirement.
Essentially, you can retire on around 700 grand worth of LICs, which would pump out around 40k of gross dividends and pay no income tax as a couple. (This is assumed the shares are owned equally between you)
Well, what about inflation…..
This is a chart from the 2016 Annual Report of the largest LIC in Australia, Australian Foundation Investment Co. (AFIC), showing dividend growth over the last 20 years.
As we can see, dividends have grown at around twice the rate of inflation for the last 20 years.
I’m not suggesting this will continue at the same rate, but I am saying if you’ve invested in good quality, diversified LICs or Index Funds, the dividends will almost certainly, at least keep up with inflation.
Historically, dividends grow faster than inflation, but it pays to be conservative.
I recommend having a cash buffer to smooth the ride, should dividends be reduced dramatically in a serious recession.
Interestingly, AFIC didn’t reduce their dividend during the GFC, though some LICs did. Retirees who were drawing down on the value of their portfolio by selling shares to live on, wouldn’t have had much fun at all, with share prices down 50%.
See my full review of AFIC and other LICs on this page.
Whatever your strategy or chosen investments are, I strongly believe many peopls are best suited to simply live off the income your assets generate. This makes for a smoother ride and a better sleep at night 🙂
So our 45k spending, required us to have around 900k in total to retire.
A shortcut to this calculation is, we needed about 20 times our annual spending.
Let’s break it down…
Essentially, to live on 45k will require a portfolio of 800k worth of Aussie LICs, paying around 4% dividends (which including franking credits, is 5.7%) and a cash buffer of 100k.
Total equity needed – 900k.
Total dividends (including franking credits) from 800k of LICs – around 45k, covering the expenses. Plus 100k cash buffer is a few living expenses to cover any reductions in dividends.
Again, have a play around with the calculator, to suit your own situation.
Our numbers are much more complicated than the example above, because most of our money is still tied-up in property.
Also, when we joined forces, we used existing equity in my partners house to buy an investment property.
Our end balance is higher than the example, due to the initial equity in my partners house, and the last 5-7 years have been quite good years as far as investment returns go in Australian Property & Shares.
We also have higher cashflow due to the room-rent-out situation, which is equal to having an extra 120k.
I could actually make a case for being able to retire even sooner, with less savings than the example. But I’ll save that for another day.
In the end, we reached financial independence at the same time, as if we had just bought shares from the start.
As you can see, with a strong savings rate, you only need moderate investment returns to retire in less than 10 years, starting from zero.
There’s no real need for leverage. You can keep it simple!
When it boils down to it, we really just want to be able to replace our work income, with investment income.
As I mentioned in this article, ideally we want to get a decent income stream for our dollars. And the strongest income we can achieve in the shortest amount of time, is with Australian Shares.
Importantly, the dividend income must also keep pace with inflation, which quality LICs have definitely proven it can.
I’ll go into more detail in future posts, but in the last couple of years, my opinions have changed a lot on investment strategy for early retirement.
I now believe, to retire as early as possible, investing for income must take priority over capital growth.
If I had my time again, I’d do it this way entirely. Every month, quarter and year, you will be replacing more and more of your income. As you throw more savings into LICs/Index Funds, your dividend income grows and grows.
Financial Independence will be reached when you have enough dividend income to cover your bills. So you can track your progress by how much of your expenses you have covered with dividends.
The best part is you will never go backwards. Even if the market drops, you are still collecting dividends and buying more shares, so your dividend income increases, covering more and more of your expenses!
What a strong and happy position to be in! Update: I wrote a post about this called, The Relentless Progress Of A Dividend Investor.
I wish I knew back then it could be this simple!
Live sensibly. Save heaps. Pick some slow and steady type investments with a strong income like diversified LICs. Rinse & Repeat. Retire on the dividends.
Everyone’s journey is different. This article may have given you more questions than answers, but there it is. Perhaps a rough guide and a helpful calculator is all you need!
Plug in your own numbers into this calculator and enter how much you are going to spend from the portfolio each year. Adjust the figures to suit your own scenario. Have fun 🙂