The conventional wisdom is often wrong.
Which means that sometimes the stuff we think we know is wrong.
I recently learnt something about financial independence that I want to share with you as an example of this.
I had always assumed that earning a higher salary must be a good thing in terms of time taken to achieve FI. Surely the faster your salary goes up, the quicker you must get to Financial Independence, right?
This seemed intuitively obvious…even though it was contradicted by what I’ve seen.
When working in finance, I noticed that Lifestyle Inflation seemed to thwart the plans of even the highest earners to escape The Prison Camp.
Actually, Lifestyle Inflation is a slightly misleading term. Spending Inflation would be more accurate, given that the more stressed you are at work, the less Life and the less Style you will end up with.
I had a striking example of this last year. Whilst I was in my notice period leaving my job last summer, I was contacted by a headhunter and asked to go for a job interview at one of the biggest global accountancy / consulting firms. Given that I was easing my way out of the Prison Camp at the time, I was unlikely to take the job, but I thought I’d drink their coffee and hear them out anyway. There is no downside in talking to smart people and hearing what they have to say.
I was interviewed by 2 partners of the firm. Last year, the average partner in that firm earned £750,000 a year. One of the two partners was the head of a significant division of the firm, so I think its safe to assume that he made significantly more than the average. I’d guess he was on maybe £1.5m pre-tax per year, maybe more.
As described in Get Rich…Honestly, I have a strange compulsion to tell the truth these days. As well as being good for the soul, this a rich source of social comedy. So I thought I’d give it a go during the interview.
I told them that I was financially independent and wasn’t really looking for another full time role. This was a clear breach of interview etiquette – a bit like going to church and letting slip to the vicar that you are a devil-worshipper.
Just in case you are going to a job interview, I should make clear that if you actually want the job, the best approach is to look “hungry”. Employers are usually looking for people who think about money in the same way that a Vampire thinks about blood or candidates on The Apprentice think about status.
The senior partner (lets call him Mr Spendy) looked me up and down. He told me that it was impossible that I could be financially independent because he was ~10 years older than me, earned way more than I did and he could not afford to stop working. In a very polite English way, I guess Mr Spendy was either saying I was lying or that I couldn’t add up. I’m not sure which would be worse in his worldview but neither seems complementary.
Mr Spendy had obviously been suffering from Lifestyle Inflation. According to him, it is hard to save when you are scraping by on a £1m a year these days. I suspect he and his wife had been spending with the same amount of restraint as an 18 year old Taliban fighter with a new AK-47 who’s just found ten crates of Russian ammunition in the cave next door.
Now a lot of people assume that spending brings happiness. If that were true, then Mr Spendy would have been as happy as a pig in shit. He would be spending his days high on endorphins, dancing down the office corridors in a state of bliss, stopping only to high-five his colleagues as he went. But I have to report to you readers, that Mr Spendy didn’t seem very happy at all. Instead, he looked suspiciously like a stressed and grumpy man in a grey suit.
Mr Spendy may have been an accountant, but he clearly needed some help with the basic arithmetic of financial independence. So, Ladies and Gentlemen, I can now unveil The Escape Artist’s FI-o-MeterTM spreadsheet. This simple model allows you to plug in your own age, income, spending and salary growth assumptions and spits out how long it will be until you achieve FI.
Unsurprisingly, I found that the earlier you start, the less you spend and the higher your investment returns, the quicker FI is achieved. But when I played with the assumption on salary growth, something strange happened. I found that the higher the salary growth rate, the longer it takes to get to financial independence. My initial reaction was that this must surely be wrong. After all, everyone knows that higher income is better if you want to get rich?
Well, yes and no. I had wired up the spreadsheet to run off an assumed savings rate of 50% (or whatever). So if salary growth increases, income rises (Duh!) but so also does your spending (at any savings rate less than 100% ).
At a given savings rate of (say) 50%, an increase in salary growth rate has 2 effects:
- Good news – you save more and your portfolio gets bigger
- Bad news – spending goes up and you now need more to achieve FI
It turns out that the second effect outweighs the first, so getting to FI takes longer.
This paradoxical finding is a function of the way in which the maths of financial independence works. Based on an assumed 4% Safe Withdrawal Rate, you need a portfolio of 25x your annual spending to get to FI. This means that every change in your spending is multiplied by 25 when considering whether you have enough.
There is a clear takeaway from this: as you get on at work, get promotions and pay rises you need to minimise lifestyle inflation and increase your savings rate. Keeping the same savings rate means that your FI hurdle is getting higher and higher. Its like running to keep up on a treadmill that is getting faster and faster.
If you think of spending as a ratchet that can only goes one way as your salary increases, then FI will just keep slipping further out of reach. The good news here is that spending is never a ratchet and you can always reverse lifestyle inflation. Salary income may depend on a degree of luck and the vagaries of other people’s opinions. But we always have control over our own spending.
Salary increases and the temptations of lifestyle inflation are the norm for hard-working and ambitious middle class people in their 20s and 30s. They work hard, keep their nose clean at work and start to get promotions. As the money starts to roll in, the pressures to spend it are all around. Remember these are also the years when our compulsion to establish our social and mating status are most powerful. For the avoidance of doubt, I am not suggesting you turn down pay rises….take the extra money and stash away as much as possible.
Have a play with the FI-o-MeterTM spreadsheet which is embedded below. Embrace your inner geek (they need love as much as the rest of us). Its instructive to see how the age at which FI is achieved varies in response to the input assumptions. Remember that, like all models, it represents a simplification of real life…just like all maps are simplified versions of the real world.
There is no need to email me or comment below saying that you disagree with the input assumptions. You can easily just change them yourself and see what happens.
The maths is simple and the results may surprise you. But the numbers do not lie.
Image credit: Tim Hunkin
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