It was my last day at work.
I was in a handover meeting with a client to introduce the new account handler. The client was a private equity firm with offices in New York and London and a couple of billion of funds under management.
I was treated to a rare conversation with the Big Cheese, the Managing Partner of the firm. This guy doesn’t get out of bed for less than a couple of million a year. If I had to guess his net worth, I’d reckon somewhere north of £30m.
When he asked me why I was leaving, I muttered something about financial independence. I was well aware how pitifully small my net worth was in comparison to his. So his response baffled me….he said he was jealous and looked forward to the day when he could afford to do the same.
I almost choked on my coffee. It could just have been small talk or a joke…but the way he said it was like he was actually fucking serious. He believed on some level that he couldn’t afford to quit yet. Perhaps he didn’t have this year’s Lear Jet or the right Carribean island…I don’t know. But I’m pretty sure a therapist would have a field day with him.
This reminded me of a true story from Winning the Losers Game. Two writers were at a party held on a billionaire’s island. The first was Kurt Vonnegut, the second Joseph Heller, author of Catch 22. Kurt turned to Joe and said: “How does it make you feel to know that our host only yesterday may have made more money than your novel Catch 22 has earned in its entire history?
Joe: “Ah, but I’ve got something he can never have”
Kurt: “What on earth could that be, Joe?”
Joe: “The knowledge that I’ve got enough”.
These stories illustrate a fundamental truth about FI. It is harder than you think to realise when you have enough. Achieving FI not only entails the discipline to accumulate wealth for a number of years but then also having the self-awareness of your own emotional flaws and biases to know what’s enough.
This often gives rise to One More Year Syndrome (OMYS). People say they cant leave a job they don’t like because now is the wrong time, given my next salary increase / share options / incentive package / bonus / new fund / carried interest / whatever.
But if you are in a well paid job, you will always be forgoing big future earnings when you quit. That is not a good reason to stay. Should you should carry on until they find you dead in your cubicle with a heart attack, a Dilbert cartoon pinned up and this months employee morale questionnaire sadly unfinished?
Our time on this planet is short. The period when we are able to run, cycle up mountains, make love, raise children, snowboard and dance is even shorter. The clock is ticking and life is what happens while we are making other plans.
OMYS follows partly from the maths of compounding. If your career goes well, you get salary increases each year. Anything that compounds over time produces a J curve effect where, after 10 years or so, the increases feel spectacular. This will (I hope) apply to the growth of your salary and your investments.
This is great news but the downside is that it will always feel like now is not quite the right time to quit The Prison Camp. The pot of gold is always just round the corner.
OMYS is powerful and can lead you to ignore warning signs that your relationships and health are suffering. When I was in the Prison Camp, I had on my arm an area of skin inflammation that worked as a stress dashboard. If I had a big presentation to deliver, was hungover or was dealing with an obnoxious person it would flare up. It reminded me of a rev counter on a car, but for stress and unhappiness. Because I had tunnel vision, I ignored it and ploughed on.
So we need to know how much is enough. The most widely quoted answer to this in the FI community is the 4% Safe Withdrawal Rate (SWR). There are different views and definitions to mine but I think about the SWR as the amount you can take (spend) from a portfolio each year such that the real value of the portfolio will likely be maintained indefinitely.
A 4% SWR implies that you have enough when you have a portfolio worth 25x your annual spending. So if your annual spending is £25,000 then you need a portfolio of £625,000. If your annual spending is £50,000 then you need a portfolio of £1,250,000. And so on.
In order to answer the question “How much is enough?” you first need to answer the question: “What are my actual spending needs?”. There is no one magic £ / $ number that is needed by everyone. It depends on how much you can live comfortably on.
A 4% SWR means every £1 you cut from your annual spending reduces the pot you need to accumulate by £25.
Cutting spending is doubly important:
1) You need to slash spending to maximise savings in the wealth accumulation phase; and
2) If you can eliminate wasteful spending then “the number” for enough becomes much lower.
Getting to a financial independence is like running a marathon…but in an alternative universe where the 26m distance is variable. The lower your annual spending, the closer the finish line.
Step 1 is to disregard all background noise from the media and the consumer suckers around you. Remember that your ancestors lived for most of the last 100,000 years without money.
Step 2 is to answer the question: where does it all go? Spend a few months recording every pound spent. This is simple – just do all of your spending from one bank account. At the end of each month download all your account transactions to a spreadsheet so each item can be classified and the data analysed. This is a powerful exercise. What gets measured gets managed and your spending will fall naturally.
Step 3 is to understand the safe withdrawal rate. The 4% “rule” is a simplification. It is based on a number of studies, the most widely cited of which is the Trinity Study (as updated). The Trinity Study showed how, over a range of time periods and market conditions, how portfolios reacted to differing levels of withdrawals.
In the Trinity Study, portfolio success was defined as not running out of money within a 30 year retirement period. And, under that definition, with a 75% equities : 25% fixed income portfolio and 4% inflation adjusted withdrawals, the portfolio success rate was 100%.
What’s striking is the number of scenarios where the portfolio actually grew in value over the long term. The study illustrates using starting portfolio values of $1,000. For a 75% equities : 25% fixed income portfolio the median value of the portfolio after 30 years was $5,968 with a 4% withdrawal rate.
On this basis, a 4% withdrawal rate is not the answer to “Whats the most I can take from the portfolio each year such that I probably won’t run out of money before I die?” Remember you are not immortal. So there is a margin of safety built in to the 4% “rule”. Do you really care if the actual SWR turns out to be less than 4%?…this probably just means you will eat into your capital before you die, not that you will necessarily run out of money.
Ask yourself whether you really want to keep working into old age to leave behind a portfolio large enough to support your adult children into perpetuity? This risks screwing up your children’s ability to function as independent adults when you are no longer around to support them.
There are other conservative assumptions implicit in the 4% “rule”:
- You never do any paid work again
- You never receive any state benefits (e.g. child benefit, state pension)
- You never downsize your house
- You never benefit from any windfalls or inherit any money
- Your spending will not fall over time (in real terms)
Can you see how unlikely these assumptions are? The first in particular deserves our attention. If you have the drive and discipline to get anywhere near FI by say 50, then you are unusual. You’re the sort of person that can earn some income in almost any state of the economy. Even if that means flipping burgers or working in the local supermarket (my preferred plan Z). More likely, you will develop your interests and passions and end up getting paid something for these.
I used to worry that I’d be too old / too under-qualified / too over-qualified to get another job or start a business. But as it turned out, the gap between my last pay cheque from my former employer and my first earned income from financial coaching was less than 1 week. It is possible to be recklessly over-conservative. Trust me on this.
There are plenty of articles on the interweb that will tell you that the 4% rate is too optimistic. These are often written by emotionally damaged men in their 40s and 50s who are basically looking for a guarantee. But the real world doesn’t work that way. There are no guarantees. You don’t expect guaranteed sunshine or guaranteed good health forever so why would you expect a guarantee with stockmarket investing?
Money accumulation can not ward off all bad things. Money is great for buying kitchen units but not so effective at staving off your inevitable human mortality. Or the slim but real possibilities of war, the collapse of capitalism or zombie apocalypse. If these things happen, neither your portfolio nor your cubicle job will save you.
Many people assume the “withdrawal rate” cant be more than the portfolio income generated. For these people, it feels reckless to spend more than the income and eat into capital. And its true that only spending income is safer and, as long as the income keeps getting paid, this eliminates sequence of returns risk.
But remember that the stash is there to serve you, not the other way around. For me, its more important to focus on total return (i.e. including capital growth) than income and to avoid “reaching for yield” when investing.
You can read the Trinity study yourself and give some thought to your own view of the safe withdrawal rate. Ultimately the question you need to ask yourself is: do you understand what you are spending and why? Then, do you have 25x the spending you need?
If so, that’s probably enough.
Image credit: http://www.getrichslowly.org
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