Setting yourself up for financial freedom in your 30s
Conventional wisdom and instincts may be guiding new investors in the wrong direction. Here are some lessons from investing in my 30s.
Last week I outlined a contrarian approach for investors in their 20s to achieve financial independence. This week we move on to a blueprint for your 30s.
First a quick recap. I suggested that the priority should be retirement. My argument was based on the power of compounding and maximising the benefits of the favourable tax treatment inherent in super. We tend to focus on near term goals first. But there is a lot to be said about prioritising retirement. Getting a leg up on retirement savings means more flexibility and optionality later in life rather than a mad dash to make up for youthful procrastination.
The oft repeated maxim is that your ‘30s are the new 20s.’ This does contain an element of truth. Many people are delaying settling into long-term relationships and starting a family until their 30s. The high costs of property also delay the purchase of a house when compared to previous generations. In my roadmap to financial independence this is a decade of transition.
Retirement remains the priority
The same logic inherent in my argument to prioritise retirement applies to your early 30s. Getting additional concessional and non-concessional contributions into super continues to be a wise move. This decade is also the time to transition extra savings from super into accounts outside of super.
Building a nest egg outside of super is the pathway to financial independence. Super is a great deal when it comes to tax but in exchange for those benefits come restrictions around when you can access your savings. Whatever financial independence means it will likely involve an accessible source of funds prior to retirement.
Your 30s are a good time to come up with an estimate into how much money you need for retirement. Estimating how much you need for retirement will provide guidance on when to direct your excess savings into accounts outside of super. I personally made this transition when I turned 33 and had a reasonable expectation that I was set-up for a comfortable retirement. The timing of this switch was a key step in my own attempt to become financially independent.
Coming up with an estimate into future spending is hard. Looking ahead 25 to 30 years may seem overwhelming. The key is remembering that perfection is the enemy of progress. This is an estimate. It is subject to change. Life will take you in many directions and the estimate can be revised accordingly. Ultimately there is value in going through the exercise and forming a baseline.
I’ve outlined a four-step process to calculate how much you need to retire. I’ve also covered it in a webinar if you prefer video as a format. Once an estimate has been made a financial calculator can determine what super balance constitutes an acceptable level to transition into a focus on non-super savings.
As a rough guide the following chart outlines milestones to achieve $1m in retirement savings at 65 given a 7 percent annual return. This chart does not include any additional savings into super. Saving for retirement with compulsory super is a lifetime endeavour but we are aiming to get a foundation early in life to allow excess savings to be directed elsewhere.
Saving beyond the compulsory super contributions can be challenging but achieving financial freedom does require outsized savings. This chart is reflective of that reality. Remember that inflation does take a toll on how far the $1m will go at 65. I’ve included an estimate to add some perspective.
Building a bridge to retirement
Retirement is a common goal that everyone faces. And ample retirement savings in super is a pathway to living a comfortable life after preservation age. Prior to preservation age savings in super are not accessible except under very specific circumstances like incapacity and severe financial hardship. Preservation age is too late for many people with the commitment and capacity to achieve the goal of financial freedom.
Each of us has a different definition of financial freedom. For some it can be reached simply by having a salary that allows some extras beyond day-to-day necessities. But for many people financial freedom involves acquiring assets that can support at least a portion of living expenses prior to the government defined minimum retirement age. These assets can provide for a career break, change in career, cutting back to part-time or early retirement.
The first step is to define the specifics around the goal of financial independence. The first step is defining the timeline for financial independence and the size of a portfolio needed to achieve the goal. Layering in a realistic savings plan allow an assessment of the feasibility of achieving the goal. This is done by using a financial calculator to calculate the required rate of return. To learn more about setting goals listen to our podcast episode on goals-based portfolio construction.
There are two primary approaches that can be taken to support financial freedom prior to retirement. Deciding on the approach will inform how savings are accumulated and invested.
The first approach is to acquire income producing assets that can support future spending. Alternatively, the pool of assets can be slowly sold off for spending needs over a set period of time.
The premise is straightforward. Assets like dividend paying shares, bonds or investment property are acquired. The goal is to grow this income stream as much as possible until a future date when the income starts getting spent.
In theory the income generated will last in perpetuity as the underlying assets generating the income are never sold. In theory this income will continue to grow which protects against the corrosive impact of inflation. In practice this isn’t quite as easy as it sounds.
Dividends get cut and eliminated, interest rate drops introduce reinvestment risk for bonds and investment properties can be vacant and require costly maintenance and renovations to retain their value. But it can be done.
I’m biased as this is the approach that I took. But I’ve also spent a great deal of time thinking about it which I covered it in my article on building an income portfolio. Focus on a mix of shares that are more likely to grow income over time rather than simply chasing yield. Widely diversify your income sources across sectors and geographies to minimise the impact of dividend cuts and eliminations.
Tax will be a challenge as income generated from your portfolio will face your marginal tax rate. Take tax into account during projections of income growth. Focus first on income that is expected to grow and delay purchasing more defensive assets without income growth such as fixed interest.
One big advantage of this approach is that it can be incorporated into your retirement plan as income should continue to be generated even after reaching preservation age.
Asset sale approach
Rather than just relying on income this approach involves using income and selling assets. This corresponds to the way that many people handle retirement withdrawals. Just like in retirement the key here is setting a sustainable withdrawal rate.
There is one major difference in building a portfolio that acts a bridge until preservation age and a portfolio earmarked for retirement. In the world of risk modelling, we are concerned with something called tail risk. It is the improbable outcomes that can create havoc if – and when – they occur.
The tail risk in retirement is living much too long. We don’t have that risk if the portfolio is only supposed to last a set amount of time. Unlike retirement the end date is known. A bridging portfolio between 55 and a preservation age of 65 only needs to last 10 years.
The below table represents the safe withdrawal rate for a 70% equity and 30% defensive (fixed interest and cash) portfolio over shorter time periods.
Setting a withdrawal rate provides the ability to calculate the size of the portfolio needed to support a given level of savings. That calculation involves dividing the amount of desired annual spending by the withdrawal percentage.
The key to this approach is to focus first on growth assets like shares that will have higher expected long-term returns and letting them compound over the longest possible time horizon. Remember that depending upon when you want to achieve financial independence you might still have a multi-decade time horizon until you need the money if you start in your 30s. The defensive assets can be purchased later.
Another key is to focus on tax minimisation. As these assets are held outside of super there is no break on income and capital gains taxes. The good news is that tax outcomes are at least partially controlled by investor behaviour. Minimising trading and extending holding periods can make a big difference in taxes owed. One way to do this are low-cost and widely diversified passive investments that track major indexes.
Laying the foundation for financial independence
It can be hard to continue on the pathway to financial independence in your 30s. This is a decade that many people settle into a career and see salary growth. However, expenses can also increase significantly if the decision is made to start a family and buy a home.
Your 30s are a time when there is still meaningful time to compound returns. Much like your 20s the focus should be on getting as much money to work in growth assets by focusing on minimising lifestyle creep and keeping savings rates high. That will enable an investor to set themselves up for the final push for financial independence. I would love to hear your thoughts at email@example.com.