Friday, May 27, 2016

This is how I plan to become financially independent by 2018

While this site is mostly about dividend investing, the topic today will be more based towards personal finance. This is because I am increasingly starting to realize that how a person allocates their money is an important decision, which has a very high weight on whether someone can reach their ultimate goals and objectives. Investing is a subset of that capital allocation strategy. One should not be investing in a vacuum – investing needs to be used in conjunction with understanding your overall personal financial situation.

Many of you know that my expected annual dividend income is at around $15,000. I have also shared with you that my annual expenses range between $18,000 - $24,000/year. According to my estimates, my dividend income will be close to the top of my expense range sometime around late 2018. Most of my passive income will come from dividends.

I expect that I would grow my organic dividend income by 10%/year, as long as I reinvest dividends. The rest of the growth will come from putting new savings to work. This could potentially add close to $4,000 - $5,000 in forward dividend income by the end of 2018. I am estimating a high savings rate, a 10% annual growth in dividend income, and tax advantaged compounding ( as most of it will be in tax-deferred accounts). This means that my forward dividend income around the end of 2018 will be close to $22,000 - $23,000/year. As you can see, even this will lead to a “shortfall” of $1,000 - $2,000/year, relative to the top range of my expected annual dividend income. If I were to wait for another year, that could potentially hit and even exceed the top range of my estimated expenses. I have said that I expect to be fully financially independent by the end of 2018, so I should stick to this goal. On the other hand, that $22,000 - $23,000 in annual dividend income is at the top of the range for passive dividend income. So I would consider that a success.

The question I have not shared in much detail is that fact that I expect to continue working at my job, for as long as I find it interesting ( or they find me needed). I also expect to write on this site at least for the next year or two. Therefore, I expect to be fully financially independent, though not retired. As a result, I expect that I will be able to generate income from dividends, from work and probably from writing. Approximately 30 – 40 years from now, I will also be eligible to receive some Social Security income. While I have worked for over a decade, I want to make sure that I have at least a decade of work experience at a higher wage, in order to get a decent benefit. Those last ten years through 2018 - 2019 would account for a larger benefit, than the first four - five years where I was working minimum wage jobs during school and/or school breaks.

Given my employment situation today, it is possible that the boss person does not keep me for the next three years. It is quite possible that they get rid of me as part of their annual layoff process. As an investor, I benefit when companies cut expenses through laying off employees. As an employee, I lose out when the company I work for decides to streamline operations in an effort to cut costs. If that were to happen tomorrow, this would lead to a shortfall of $3,000 - $9,000 in annual passive dividend income for me by 2018. This means that around 2018, I will be generating $3,000 - $9,000 less than the $18,000 - $24,000 in annual dividend income I am ultimately targeting. This is because I may have to tap my dividend income from all sources today, which would leave little if any money to be reinvested.

This exercise got me thinking how valuable income really is for retirement planning. I thought out about a few things, and a few scenarios of things I could do to get to my goals, no matter what happens. I have found that it is important to identify my goal, and then think of multiple scenarios, as well as multiple different ways to  attack the problem.

1) For example, in order to earn $3,000 in annual dividend income, I would likely need around $100,000 to invest today in a portfolio of dividend paying stocks. This is because most companies that I might consider investing in today will yield something like 3% on average. While valuations are close to the top of the range on many companies I am monitoring, it may make sense to allocate that money for income. If I had a shortfall of $9,000 however, I would need something like a $300,000 lump sum to reach out my goals. This is a very large amount of money, which few have just laying around, ready to be deployed. This means that if I got laid off tomorrow, I should find a new job, in order to let my dividend income compound and add new funds to my portfolio. If I keep a high savings rate, I may reach my goals on time.

2) Of course, if I could compound my income at a reasonable rate for three years, I may reach the low end of my target expense range pretty easily. This is a scenario where I let my dividends compound for three more years, but I live off other income I generate. For example, if dividends grow at a rate of 7%/year and I manage to reinvest my dividend income at a starting yield of 3%, my total dividend income will increase by 10%/year.

Forward Dividend Income

While I would hit the bottom of my range, I would have a low margin of safety in financial independence this case. I do not want a situation where I have no margin for error, in the case that 2018 is a repeat of 2008 – 2009. Furthermore, I am not comfortable projecting numbers onto the future, because the future is unpredictable. It is quite possible that the projections I am making will turn out to look quite foolish for those of you who revisit this article in 2019.

3) Under the situation discussed in point 1), I would have a shortfall of $3,000 - $9,000. Under scenario 2), I would have a shortfall of $6,000 by 2018. If I found a way to generate recurring income on the side in the amount of say $6,000/year, I would theoretically have a much lower capital requirement for my “passive income”.

For example, if I were in my early 60s, I would be eligible for Social Security. It is possible that this gap will be filled in by this pension. I view Social Security as equivalent to having a treasury inflation protection bond, since this source of income maintains purchasing power over time. Therefore, if I were to generate $12,000 in annual income from Social Security, I would view this as having an asset that is worth $300,000 - $400,000 today. I came up with the numbers using an interest rate of 3% to 4%. In other words, I view this income stream as part of my fixed income allocation. Of course, if you were to buy treasury inflation protected securities today, the best yield you will get will be somewhere around 1.00% for the longest maturity bond. However, once you die and once your spouse dies, your work benefit from a pension is gone forever. With bonds, there will be something of value left ( unless you decide to roll the dice and touch principal in retirement)

That being said, if my portfolio was worth $600,000 - $800,000, and was invested entirely in dividend paying stocks yielding 3% on average today, I would not need any allocation to fixed income under the scenario addressed above. The Social security trust would be sufficient for my purposes as a fixed income substitute.

It is also possible to be overexposed to fixed income if you also had a pension from a stable company. In this case, taking on more risk and investing everything in stocks would be a good decision that would diversify me better.

4) Again, as we saw in scenario 1), I would have a shortfall of $3,000 - $9,000. Under scenario 2), I would have a shortfall of $6,000 by 2018. Under scenario 3), pension income could more than compensate for this shortfall.

In my case, I will be ineligible for Social Security for at least 30 - 40 years. After all, I graduated college in 2007. Therefore, I need to figure out ways to cover this shortfall. The easiest way to do it is to work in some extra capacity. I would assume that I can earn $4,000 by trading some time for money. If I were to earn $20/hour, I would cover the shortfall after working for 200 hours. I believe that spending 6 - 8 weeks of work per year, and 44 – 46 weeks of vacation sounds like a pretty decent plan for me. Unfortunately, if I had to greet people at the local Wal-Mart however, I would likely have to spend 500 hours at this activity at a rate of $8/hour. This translates into roughly 12 – 16 weeks of work, which is not too bad either.

To put things in perspective, an annual dividend income of $24,000 translates into 1,200 hours of work at a rate of $20/hours. Using an hourly rate of $8/hour however, this translates into 3,000 hours of work. It is always helpful to see money as units of energy/amounts of time, rather than simply units of currency. It is extremely humbling to realize that if I achieve my goal of generating $24,000 in annual dividend income, this would be equivalent to earning as much income by doing nothing, when someone else could have had to spend 30 long weeks chained to a desk. By earning $24,000 in annual dividend income, I won’t have to spend 1,200 hours to work. As we all know however, a lot of professional services jobs that pay at least $20/hour are actually salaried positions, which require much more face time at the job than a mere 40 hours/week. Chances are that your salaried position also receives small raises as well.

To add insult to injury, my comparisons use nominal dollars, and do not account for taxes. In the case of qualified dividends, a single person does not have to pay any taxes as long as they earn less than $47,750/year. The amount for a married couple is $95,500/year. So in order to generate $24,000 in after-tax income, a single person would have to earn over $28,400 at a job they may not really enjoy.

If you decide to be self-employed, you will need to earn even more money, in order to pay for your portion of the self-employment tax. In my case, I generate some income from this blog. I am lucky, because the sum of dividend income and my blog income has covered my expenses for several years in a row. This has allowed me to save a large portion of my after-tax salary. The high savings rate has definitely helped me grow my dividend income base. The recent emphasis on putting everything in tax-deferred accounts has sped things even faster. The problem of course is that blog income is very fickle, and requires a lot more effort than working for someone else. On the other hand, the few dollars I earn for displaying relevant ads to 1000 of you is more diversified than the dollars I earn from a single employer.

Given all the information in point 4, it is no wonder that passive dividend income is more valuable than employment income from the standpoint of life energy exerted, and taxation.

On the other hand, you need a portfolio of dividend paying stocks worth anywhere between $100,000 to $133,000 in order to generate $4,000 in annual income ( using dividend yields ranging between 3% and 4%). So it is important to keep things in perspective from as many viewpoints as possible.

5) We talked a lot about income in points 1) – 5). But we haven’t really talked about expenses.

Let’s assume that I manage to cut expenses by $1,000/year. This is equivalent to me having to save $33,333 less at an yield of 3%. If I manage to permanently reduce some of my expenses, I would need less money to save, which would further drive down the amount of time I need to declare myself financially independent. If I manage to reduce my recurring expenses even further by say $2,000/year, I may have to save $67,000 less than expected. This would also translate into me being able to reach my goals faster and it would also translate into me being able to have a higher margin of safety.


So what was the point of this article?

I believe that this article outlines a few viewpoints that show the value of having multiple streams of income. Over the past eight years, I have focused on growing my passive dividend income. Dividend income is valuable, when you look at it from different perspectives:

1) From a tax perspective, a dollar of dividend income is taxed less than a dollar in salaried income or interest income

2) From a life energy perspective, a dollar of dividend income is more valuable than a dollar of salaried income, because it hardly requires as much time or effort to be maintained once it is set up.

Of course, dividend income is not the only type of passive income available. There is also pension income, which could be extremely valuable for a retiree. This is because the benefit has a high replacement cost if you were to build a portfolio to generate that amount of income. Unfortunately, to get to reasonable levels of dividend income or pension income, you need to spend a lot of time upfront in building out your benefit. Sometimes, if there are shortfalls in income, it could be helpful to also focus on some side “active” income. If you manage to generate $10,000 in annual income through a part-time job or a consulting gig, you will reduce your needed nest egg by as much as $250,000 - $330,000. However, you would have to expend your limited units of life energy for each dollar you generate this way. This is why it is important to only focus on things you enjoy, when you look to generate side income in retirement.

In general, it is important to outline your goals, track your progress towards them, and think about ways to keep yourself on track even when life throws curve-balls at you. In my case, I have spent a year and a half without a job in the past decade, and still managed to be on track because I have developed several different streams of income in my life and because I am very frugal. It is much easier to live life when you are not dependent on any one stream of income for your livelihood. It is also important to diversify within different income streams. For example, I generate dividends from a large number of companies that do business around the world. I also generate income from my day job, plus some income from interest and from this blog ( which is the least reliable of all). It is also helpful to downsize expenses when you do not have a lot of fixed costs and you do not need high prized status symbols to show your importance to the world.

This is why I would encourage all of you to think of ways to generate income, outside of your job. This could include dividend income, rental income, or any other type of side income that could provide an extra margin of safety in your financial independence. As we have discussed plenty of times before, it is important to be diversified.

Thank you for reading. I would be curious to hear from you in the comments section.

Relevant Articles:

From zero to $15,000 in dividend income in 8 years
Building my dividend snowball to $30,000 in annual dividend income by 2024
Life after Financial Independence
Living off dividends in 2016 – My New Goal
How to Earn $95,000 in Qualified Dividend Income, and pay no taxes

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