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Shani Jayamanne: Welcome to another episode of investing compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

Mark LaMonica: Well Shani, we're going to do a plug for our conference which is coming up. So it is on the 11th and the 12th of October and the 11th is an all-day digital day and then the 12th we are doing live in Sydney at the ICC. If you don't live in Sydney, you can sign up and we're streaming the whole thing. And the exciting thing about the conference for me is that Shani set up the whole agenda. So what are people gonna hear about at this conference? Who are they gonna hear from?

Jayamanne: Yeah I mean it was very, very difficult to narrow it down to one day, which is why we have two this time. I'm pretty excited about some of the sessions that we have. So the, there is a gold medallist fund manager panel, so funds that we rate gold, we've got some of the portfolio managers and representatives coming along and they're gonna talk about their top picks from their funds. We've got Jodie Fitzgerald from MIM – so that's Morningstar Investment Management – and she's going to talk about how to make your retirement portfolio last longer. We've got Paul Blockson from HSBC and he is a commodity specialist but an economist and he's going to talk about how commodities have impacted the Australian economy and how it will impact future returns. So those are a few of the ones that I'm excited for – and Annika Bradley and Duncan Burns from Vanguard. So they're doing a fireside chat – there's just a lot. It's like choosing your your favourite child. You know you've sort of.

LaMonica: Well, one thing I will point out is the child you did not choose, was me. I am also doing a presentation but.

Jayamanne: You're doing 2 presentations.

LaMonica: Yeah but anyway

Jayamanne: If you want to meet Mark, you should come to the conference.

LaMonica: Okay, well, you're more of a draw. So if you want to meet, Shani, you can also come to the conference, but.

Jayamanne: You can tell we're not salespeople but come to the conference.

LaMonica: Exactly. Yeah. Come to the conference. But anyway, why don't we get into today's episode? And if you have questions about the conference, you can also email me, yeah.

Jayamanne: Yes, and you can find more information in the episode notes, so we'll put a link in there.

LaMonica: Okay, exactly. So today we're going to cover a three-step process for financial independence and I was just saying Shani this episode is guaranteed to be popular, right? Because people love three step processes.

Jayamanne: We love a listicle.

LaMonica: Yeah, exactly. And people love financial independence.

Jayamanne: Yes, but the first thing to say is that while everyone loves financial independence, it means something different to everyone. And our notion of financial independence tends to evolve overtime.

LaMonica: Exactly – so it is a bit of a journey. And we actually sent out a survey recently to our subscribers asking their definition of financial independence and the answers we received were reflective of that.

Jayamanne: They were really interesting. And let’s just talk go through two which reflected the point that it can mean different things for different people, and it evolves as our lives evolve. One survey participant said, “Not worrying about week-to-week financial obligations or unexpected expenses like car repairs”.

LaMonica: And I love that answer. So one of the things that we tend to ignore is how much of a sense of security people get just from having an emergency fund. So just building up an emergency fund can remove a lot of vulnerability.

Jayamanne: That’s true. And one of my first financial goals was just that. To have an emergency fund.

LaMonica: Yeah, mine was well. And I think Just the notion of not living paycheck to paycheck was huge for me. And at the other end of the spectrum, we had a respondent say “Having the freedom to choose their job and working hours, or even have the option to quit paid employment entirely to pursue their passions”.

Jayamanne: That is the old tell your boss to take a hike sense of financial independence. 

LaMonica: Yeah, no, exactly. And if it was my passions, it would be just probably sitting around drinking wine. But I think those two answers were really reflective of how my own thinking has evolved. So, I personally I want the ability to take advantage of all the opportunities that life has to offer. And while we may not know what those opportunities will be there is a large part that financial flexibility plays in those decisions. 

Jayamanne: So whatever your idea of financial independence may be and however it may evolve over your life we are going to give you a three step framework to getting there.

LaMonica: Okay so a good place to start is obviously with the first one right Shani? And that is building a cash cushion.

Jayamanne: And cash is an interesting one. Investors tend to look down on cash and there is a good reason for this. The returns on cash over the long-term have barely exceeded inflation. That means from a purchasing power perspective you are basically breaking even by holding cash.

LaMonica: And not only that but there is an opportunity cost to holding cash. Most of us need returns that exceed inflation to accomplish our goals. So naturally by holding cash we are forgoing those opportunities. But cash has several advantages and is a key part of our financial well-being.

Jayamanne: And that is reflective in what that first survey respondent said. An emergency fund is a key part of investing. As investors we don’t want the timing of our investment decisions to be dictated by external forces. And in this case that external force could be an unexpected expense.

LaMonica: Exactly. The last thing we want is a home repair or a car repair to mean selling off shares. But what we need to remember is that the opportunity cost of cash actually goes down as we age. So when we are young we want to keep the minimal amount in our emergency fund to give us security. And in some ways this is made easier because the size of the emergency cash needs we have typically gets higher as we acquire more stuff and as we age. So if you don’t own a car or a house the potential short-term uses for cash is lower. 

Jayamanne: And let’s go through an example of the opportunity cost of holding cash and how that decreases over time. Let’s say you earn 3% a year in cash and 7% a year in the share market. If you are 25 years old and you have $10k in cash instead of in the share market your opportunity cost until you reach 65 years old is $48k. That is the 4% difference in returns over a 40-year time period.

LaMonica: And if you are 55 years old the opportunity cost is only $14k because you only have a 10-year time period to compound those extra returns from investing in shares.

Jayamanne: The other cash consideration and way it can help returns is when you are older and transitioning to retirement and can again get forced into a situation where you are selling shares to fund your life in a bear market. And we’ve covered this multiple times, but that is sequencing risk and you don’t want to sell when the market falls. Having cash can allow you to ride out the downturn.

LaMonica: So, step one is to build up a cash buffer. Keep it at the bare minimum when you are young and add to as you age and have bigger potential liabilities and the opportunity cost decreases. And just remember that cash has value.

Jayamanne: And we are making a very big assumption here that you have a share portfolio to sell off if you have short-term expenses. Many people don’t have this. In this case the cash buffer is protecting you from having to borrow money – most likely on a credit card – to cover those short-term expenses. The interest rates are high, and they compound until you are able to pay off your debt.

LaMonica: Alright so let’s move onto step two Shani. And that is to focus on retirement. And we have deliberately put this second because we both believe that the next step to getting to financial independence is to take care of retirement as soon as possible.

Jayamanne: And this is the case even if you don’t want to retire early. Because there are big tax advantages to investing in super. And getting money into super early means that those tax advantages will compound over time. And we will talk about the downsides in a bit but let’s walk through how this works.

LaMonica: We’re are going to go through an example and this example is a little bit complicated, so there’s going to be a lot of considerations here, but the premise is the following scenario. Let’s say you have $10,000 extra a year to invest which you will have between the ages of 25 and when you retire at 65. This $10k is pre-tax meaning it is in salary. Over those 40 years you have a 10-year period where you can direct those funds into super and a 30-year period where you can direct those funds into an investment account outside of super.

Jayamanne: So let’s talk about taxes. The funds that go into super in this scenario will be taxed at 15% as we are assuming they are concessional. Concessional contributions have a limit of $27,500 per financial year. And the funds that go into the non-super account will be taxed at the marginal tax rate – we will use two different ones in this example.

LaMonica: And you will earn returns in these investments of 7% a year. Now for the sake of this model we expect those return to come from both dividends and capital gains and we assume that you are paying taxes each year. We are assuming you pay taxes each year on the whole 7% return and that there is no long-term capital gains discount.

Jayamanne: In both super and outside of super there is a discount in capital gains taxes for assets held longer than a year. But by ignoring that discount on both we can equalise the taxes paid for income and capital gains. Since we are doing that for both accounts it really makes no difference in this scenario.

LaMonica: That was a lot of rules but it is important to think through those considerations. As I said you will make contributions for super for 10 out of the 40 years. You can choose to make them between 25 and 34, 35 and 44, 45 and 54 and 55 to 64.

Jayamanne: And the best way to build your total wealth is to make the super contributions between 25 and 34 so the tax savings in super can compound as much as possible. At a 32.5% marginal tax rate the difference in total wealth between making those super contributions in the first decade of the 40-year period and the last decade of the 40-year period are $1,054,050 and $797,306. That is a huge difference.

LaMonica: If you are in the highest marginal tax bracket the difference is between $928,300 and $557,374. This is a larger difference because the compound tax savings are bigger. And because of the way we modelled the taxes both accounts would effectively be tax free and in cash because you are selling each year and getting those short-term capital gains.

Jayamanne: And this can be a concept that people tend to shy away from. If your goal is early retirement, working part-time or following your passion or taking a lower paid job many people instinctively want to address that goal first. Retirement is far away after all.

LaMonica: But the lesson is important. Get as much money into super when you are young as possible. The longer you wait the bigger the impact will be on your total wealth. Those additional contributions are more valuable when you are younger. They are less valuable when you are older.

Jayamanne: And obviously you will continue to save for retirement through mandatory contributions as long as you work. But if your idea of financial freedom is early retirement or part-time work that is going to impact your level of contributions.

LaMonica: But remember one of the great things about compounding of returns is that the early contributions can more than make up for missing contributions later in life.

Jayamanne: Once you’ve established an emergency fund and once you’ve gotten your retirement taken care of it’s time to turn your attention to the final stage of financial independence. This is having flexibility before you’ve reached your preservation age. To take advantage of opportunities, to retire early, to cut-back on work or to switch careers.

LaMonica: And this is a case where we can look at what we exchange the tax benefits from super for. And that of course is a set of rules so in order to get those tax advantages, we need to follow those rules.

Jayamanne: The first rule is that except under very specific circumstances we can’t touch the money until we reach preservation age. And this of course means that super alone will not allow us to retire early.

LaMonica: The other thing we are giving up is an understanding of what the rules will be for super when we want to access the money. The super rules change almost every year. And we can all expect them to continue to change. And the latest major change was the additional tax on super balances over $3m.

Jayamanne: And whether you think that is good policy or bad policy we can say that the people that have amassed more than $3m in super did not know these rules were going to be there when they were saving into super.

LaMonica: And once again our job is not to tell you what you should think of these rules. But we should point out that there are two places where individuals in Australia have accumulated a great deal of wealth – in their homes and in super. So if the government needs money or if the government wants to lower inequality I think we should all expect that the places they will go are to residential real estate and into super.

Jayamanne: And the government can obviously change marginal tax rates as well. They can change the amount of tax you pay on dividends and capital gains outside of super.

LaMonica: Exactly and in theory you have more flexibility there because the money isn’t locked in super but still worth noting. Although I can’t foresee any possibility of taxes being equal or even that close between super and non-super. 

Jayamanne: So the lesson here is that we each need to weigh the benefits and costs of investing in super. But if we’re looking to gain financial independence during what the government considers working age, we need to have assets outside super. So once you’ve taken care of retirement it is time to turn your attention to building these assets.

LaMonica: And there are two approaches you can take to building up and spending money to gain financial independence prior to preservation age. And it doesn’t really matter if you want to retire early, cutback to part-time work or accept a lower salary.

Jayamanne: All of that costs money that will have to spent from non-super sources. But we will consider a scenario where you want to retire early.

LaMonica: The first approach is to create a pool of money outside super and use that as a bridge between when you stop working and when you can access retirement funds. So the concept is simple – if I want a certain amount of money a year prior to preservation age I need to fund that from this pool of assets.

Jayamanne: Whatever the time period is, you need to set a safe withdrawal rate to make that money last. That could be 10 years, it could be 40 years. And the driver of what that safe withdrawal rate or how much you can spend each year will be the amount of time you need the money to last – the longer that time is the lower the withdrawal rate – and the probability of running out of money that you are willing to accept.

LaMonica: And it is important to note that any safe withdrawal rate is simply based on the probability of not running out of money in different return scenarios. Let’s use an example from Morningstar’s state of retirement report.

Jayamanne: We are going to imagine looking at a 90% probability of success – basically a 90% chance you won’t run out of money in the time period you choose – with a 100% allocation to shares. If you want the money to last 10 years you can safely withdraw 8.5% a year. If you have a 40-year time period, you can withdraw 3.1% a year. Any time period in between 10 years and 40 years and the withdrawal rate varies between 8.5% and 3.1%.

LaMonica: Now a couple caveats here. We don’t know the returns we will achieve. If returns are really high, you might have a great deal of money left at the end. If the returns at the beginning of your withdrawal period, are the 10% poorest in history you will run out of money – that is the 90% probability of success.

Jayamanne: And there are two things to think about here. How aggressive you get with the withdrawal rates is based on your ability to survive running out of money in this time period. And obviously running out of money provides less security during retirement because you only have your super. So this is probably based on how confident you are in retirement.

LaMonica: The second consideration is tax. In Australia during the pension phase on super you pay no tax on withdrawals. So saying a 4% withdrawal rate means that you can spend 4% of your super balance. But the withdrawal rate on a taxable account is different than the spending level. That is because you need to pay taxes when you sell appreciated assets or receive dividends.

Jayamanne: The advantage of spending down your assets prior to retirement is that it makes it more likely that you could qualify for the aged pension. There is an asset test for qualifying for the aged pension. These asset tests have some complexity but basically at a high level outside of your primary residence you can qualify for the full pension if you are single and a homeowner with $300,000 in assets and $451,000 if you are part of a couple.

LaMonica: If you don’t own your home the assets are $543,000 for somebody single and $693,000 for a couple. There are then qualifying levels for the partial pension and the transitional pension.  

Jayamanne: Let’s move onto the next approach of creating a stream of income that you can access prior to preservation age. And the concept here is pretty simple – if you just spend the dividends earned on your account you won’t run out of money. The amount you take out each year may vary as dividends vary but since you aren’t selling off the assets you will keep them.

LaMonica: In this case these same assets can generate income far beyond your preservation age and keep generating income during retirement. That is a win. But there is a problem.

Jayamanne: The main problem is that this is hard. It is hard to do this at retirement age, but it is even harder to do it earlier. At 60, 55, 50 and younger. That is because you have less time in order to compound your income growth. Time is the best friend of an investor. You are reducing that. It especially hard if you don’t start really early and many people don’t get their financial act together early in their working lives.

LaMonica: And the issue that you run into with dividends is that there is a conflict in income investing. If you invest in the highest yielding shares it could be a dividend trap and cuts may happen in the future. And if they aren’t cut the highest yielding shares often pay out a good deal of their earnings in dividends. They do this because there aren’t other opportunities to grow their business. And if there are opportunities to grow a high dividend starves the business of capital to grow. So the dividend doesn’t grow as much. And you need fast income growth to get your income high enough to give you financial independence.

Jayamanne: The other option is finding shares with lower dividend yields where the growth prospects of those dividends are strong. The issue of course is that your savings don’t buy you as much income and it takes years for that growth to compound. In some cases you don’t have those years. 

LaMonica: And Shani, we’ve done a whole episode on income investing so we won’t spend too much time on it but the point is to work out a plan of how you can there with income if you think it is a more attractive option than the bridge to preservation age. 

Jayamanne: And for most people this income strategy doesn’t equate to a full early retirement. Instead, it makes a bit more sense as a way to transition to part-time work or perhaps a lower paying job.  

LaMonica: So there we have it. The three steps to financial independence. Build up a cash cushion to protect yourself, get yourself on track for retirement by maxing out super contributions early and then focus on building a pool of money that can either be spent or support an income stream prior to reaching the preservation age. 

Jayamanne: So Mark. you're a little bit further along in this journey than I am. How is your journey to financial independence?

LaMonica: Was that your polite way of calling me an old man?

Jayamanne: I said you were a little bit further than I am.

LaMonica: Okay, I’ll, I’ll take that. So I’d say I am through two of the three steps Shani. So I have an emergency fund which I’ve increased over the years as my potential liabilities have increased. I focused when I was younger on maxing out my retirement accounts and I’m comfortable that I’m on track and don’t need to make contributions to super above and beyond the mandatory contributions to super. The third step is an interesting one.

Jayamanne: Well tell us a story.

LaMonica: Okay well, it’s, it’s not much of one but my goal when I was younger was to retire early. And I was going to do it by building an income stream to support myself prior to retirement. But a couple things happened and the first thing was just that my priorities have changed for my life. So I started thinking about staying engaged and challenged and thought that giving up work wouldn’t be the best step for me. But another thing happened and I started letting lifestyle creep take over.

Jayamanne: And lifestyle creep is just our tendency to raise the bare minimum standards of our life as we make more money and start experiencing a better lifestyle. 

LaMonica: And the challenge was that this kept increasing the amount that I needed to generate in income to support my life. So it became harder and I ran into some of the challenges that face growing income which we’ve covered. 

Jayamanne: And as you’ve talked about previously you are instead using income to enhance your lifestyle.

LaMonica: That is true. And I think the lesson here is that goals are going to shift over time. Your view of financial independence are going to change. But the one thing that isn’t going to change is that the later you get started the less options you have for your future. And I saved and invested when I was young and that has given me more flexibility now. And that flexibility is at the heart of any definition of financial freedom. 

Jayamanne: And this is an important lesson. The cornerstone of the FIRE movement is cutting back on lifestyle creep and living quite frugally. This allows you to save a lot but also means your life doesn’t cost as much so you don’t need as much money to reach independence.

LaMonica: And the spending side of this is of course important. It isn’t really the approach we’ve taken in this episode but that should be part of anyone’s plan for financial independence.

Jayamanne: And one way that gets you a long way towards independence is to pay off your house. Paying a mortgage or rent is one of the biggest expenses in most people’s budget. For most people paying off your house will mean a good deal less money needs to be saved in both retirement accounts and for pre-super independence.

LaMonica: Absolutely. And the value of living mortgage free is huge. But you still need money. And the three-step process we outlined is still needed to reach independence.

Jayamanne: So there you have it. A three step plan to reach financial independence. And the last point is that this is hard. And it is unusual. So to achieve the goal of financial independence involves sacrifices to save and invest money. And it means saving more money than the average person. So keep in mind that you can’t achieve different results without taking a different approach. 

LaMonica: All right. So that is our episode. All three steps. And once again, we would love it if you came and joined us at the conference. So see the show notes for a link to sign up and register.