Even you can retire early. The traditional path to retirement is to buy and hold a basket of stocks and bonds for 30 to 40 years until they compound sufficiently into that “magic number” of 25 or 30 times your expenses. Voila! Financial freedom at last! But what about those who don’t want to work for 30 to 40 years? What if you want to retire earlier?
Thankfully, the FIRE (Financial Independence Retire Early) community has questioned the wisdom of working 40 years and then enjoying life in retirement when you are too old or infirm to enjoy it properly. Yes, you can still shoot for that magic number, no harm in that, but what is most important is to create sufficient passive income to cover your living expenses and there are many ways to do that a lot faster than waiting for your investment portfolio to compound over time.
The plan for financial freedom is actually quite simple:
- Calculate your total living expenses (including healthcare or medical insurance and taxes).
- Buy or create income producing assets.
- When your income producing assets exceed your living expenses you can declare yourself financially free and retire early!
Important caveats:
- Make sure your income producing assets will keep pace with inflation. A bond ladder will produce income, but it will get demolished by inflation.
- Make sure you have diversified sources of income so that if one stream should run dry, you have others.
- Insure what you can’t afford to replace.
Most financial advisors/planners will encourage you to focus on accumulating an investment portfolio of stocks and bonds sufficient to create an income stream in retirement.
There are just two problems with this:
- Compounding takes time. It typically takes 30 to 40 years of investing to achieve a portfolio that is large enough to retire on. At 7% returns your investment will double roughly every 10 years. If you have $100,000 at 30, that will, with a bit of luck, turn into $200,000 by 40, then $400,000 by 50, $800,000 by 60, and $1,600,000 by 70. That would generate an income of $64,000 a year, but you’ll be 70 before you can enjoy it. Not exactly an early retirement plan and assumes no market crashes that decimate your portfolio just when you are about to retire.
- Investment fees of 2% can double the amount of money you need to save before you can retire, further delaying your retirement plans.
If you want to retire sooner, you’ll need a different, faster plan. Many of the FIRE bloggers choose the super frugality path, cutting their expenses to the bone and investing the difference to shorten the time to retirement. I’m not a fan of compromising my lifestyle unduly, having a fondness for a weekly massage and a house keeper, not to mention dining out and travelling. So I needed a more creative plan that focused on creating passive income streams that would cover my expenses. And these income sources need to be well diversified so that if one fails, others will still produce.
Let’s take the average US income of $50,000 and start with replacing that. If you used the magic number formula, you’d multiply that by 25 and see that you’d need an investment portfolio of $1,250,000. Or, you could create a variety of diversified income streams and get there faster:
| Portfolio of dividend stocks $200,000 at 3% = | $6,000 year |
| Net rental property income ($100K down) = | $9,600 year |
| Royalty, patent or licensing income = | $10,000 year |
| REITs (commercial property) = | $5,000 year |
| Business income from hobby or lifestyle business = | $24,000 year |
This basket of income producing assets works out to a passive income of $54,600 a year.
Now, if you’ve paid off your mortgage, this is enough to live a comfortable lifestyle. As you get older, you might sell your rental property and instead invest in an inflation-adjusting annuity to simplify your life. Social Security will kick in at 67 or 70 and you can then use that income to replace your hobby or lifestyle business if you want.
The goal is to create a perpetual stream of inflation-adjusting income that will outlive you. Now, if you want to do that with paper assets, then you might want to consider some of the All-Weather or Permanent Portfolios such as Ray Dalio’s, the Butterfly Portfolio as described at PortfolioCharts.com.
Most people know what their income is and working to create income streams to replace their income is fairly easy to figure out. Keep adding income producing assets until you get there. And, if you are going to work for some time, you might as well enjoy the work you do. Consider taking the career assessment tests in the Career Change Kit if you aren’t enjoying your job.
