The Impact of Coronavirus on Financial Independence

The stock market crash caused by the Coronavirus (COVID-19) has hit hard. Top to bottom, the ASX 200 has fallen about 30% and we don’t know if it will continue to fall. What I found incredible about this downturn is how fast it was. The GFC back in 2008 was a much more staggered downturn whereas the COVID-19 crash looks like a straight line down.

The only way to prevent the spread of this virus is to restrict movement. However, restricting movement hurts the economy. If people cannot commute to work, travel to another country to do a business deal, go to a shop to buy something, etc then trade doesn’t happen. If trade doesn’t happen, businesses collapse. This may lead to businesses firing staff, which reduces spending, which leads to more business collapse.

Diversification

This whole incident demonstrates the importance of diversification. Even though I am heavily invested in high-dividend Australian equities, the risk with focusing on a narrow asset class is a lack of diversification, so my focus on high-dividend Australian equities has definitely not helped me during this market crash.

The video above (with overly dramatic music) demonstrates how widely different countries’ stock markets have performed during the virus outbreak and illustrates the importance of diversification. Chinese equities have held up very well compared to the stock indices of other countries. Other assets that have held up well are gold, government bonds, and the US dollar.

All this demonstrates the importance of diversifying across a range of different assets. Because a significant amount of my wealth is in high-dividend paying Australian equities (e.g. IHD), I have made significant six-digit losses. Investing with leverage doesn’t help either. Nevertheless, I am relatively young and feel hopeful that there will be a recovery. As I get older, I will definitely reduce risk by diversifying into a variety of safe haven assets, but while I am young I do feel an obligation to invest in riskier and more volatile assets.

Mass job losses as a result of COVID-19

Something else that the COVID-19 crash demonstrates is the importance of financial independence. Being able to live off your investments forever is important because your job is not certain. Many people have an optimism bias and think they will be employed forever, and they structure their life around the assumption that they will always be employed. However, even what is perceived to be a safe job can be unsafe. For example, a pilot may think their job is bulletproof. They may think that air travel will always happen, so their job is safe. Black swan events do happen.

In my opinion, you should aim to be financially independent as fast as possible, as soon as you leave school or university. This involves a combination of high savings as well as cutting costs of living. If you are able to live off $10k per year, you only need to save $250k in order to retire (according to the four percent rule). If, when you are young, you inflate your lifestyle to $40k per year in expenses, you will need to save $1 million. The better you are at being content with living on little, the quicker it will be for you to be financially independent.

Surviving self-isolation

As a result of Covid-19, I am now working at home. I find there are pros and cons to working from home, but I am getting used to it. The biggest pro is being able to wake up about one to two hours later because I no longer need to get dressed or take the train into the city. Although not essential, I feel it is good to start the day by having a shower, wearing reasonably nice clothes (so you look okay when video-conferencing), and having a coffee. Not only is being clean, neat, and caffeinated important in itself, but the ritual of these activities helps to put your mind into “work mode.”

I have been to the supermarket in these new times, but it is not a pleasant experience. Everyone seems nervous and anxious. They stare at you as if you are going to grab the last pack of toilet paper. There are many stories of shoppers fighting over toilet paper, which I think is disappointing. To avoid crazy people and to avoid being infected, as much as possible, I am trying to avoid going to the supermarkets by buying essentials online. Many essentials can be purchased online, from food to toilet paper. Hoarding toilet paper, in my opinion, is not a good idea because toilet paper prices are high now, so you should only buy what you need and put any excess cash into the stock market.

The key to surviving Covid-19 is to have good respiratory health and a strong immune system, which is why exercise is important. Even though the government has imposed restrictions, exercise is still allowed where I live, so I make sure I ride my bike around the neighbourhood regularly. Riding a bike is not just a form of exercise but is also a cheap way to commute. Surprisingly, the park trails are filled with people walking their dogs, so I find that it is safer to ride on the roads where there are almost no cars.

While the global community deals with Covid-19, what is becoming clear is that many of those who contract the virus have no symptoms or mild symptoms and are able to make a strong recovery thanks to a strong immune system. As such, I have been trying to eat as much fruit and vegetables as possible.

Now is the time to dollar cost average into the stock market

I have heard of many people selling shares or converting their superannuation into 100% cash. The Australian government will soon allow those who are affected by Covid-19 to access $10k from their superannuation. This is a bad idea. Now is the time to be buying stocks, not selling.

“The best time to buy is when there is blood on the streets, even if the blood is your own.” Baron Rothschild

Will Australian property prices go down?

It makes sense that property prices are not immune from Covid-19. If enough people are unemployed from Covid-19, they will not be able to meet their mortgage obligations nor will they be able to save for a deposit on a property. Property investors typically rely on tenants to pay them rent so they can meet their own mortgage obligations, so if tenants lose their jobs, landlords may be required to sell their properties. Falling demand and rising supply push prices down.

However, there are a number of policies put in place that can prop up property prices e.g. lower interest rates and six-month mortgage holidays. These measures put in place to stimulate the property market, in my opinion, are good reasons why you should not buy a property now. Because the stock market has fallen so violently, the prices for these assets are very attractive relative to historical earnings (and dividends) whereas if property prices are propped up, you are not getting any discount on your purchases relative to rental income. The cheaper you buy your investments relative to income, the more they will go up when there is a recovery.

The silver lining

Although the Covid-19 outbreak has caused considerable wealth destuction and job losses, there is a silver lining. One benefit is that carbon emissions are falling sharply across the world, but unfortunately when the recovery happens, all this may be reversed. Another benefit of Covid-19 is that remote working systems across the world will be strengthened, which means over time more and more workers can work either fully remote or partially remote. This means I may be able to pursue my dream of becoming a “digital nomad” while still doing the 9-5 job I am familiar with. Usually those who work remotely are people with families, tech workers, graphic designers, etc, but the Covid-19 outbreak will normalise remote work for everyone because it has forced everyone to work from home (unless the job cannot be done at home). This is good not just because it means you don’t need to commute but it also means you can potentially travel while you work or work from low-cost-of-living countries. A world of remote work could look very different to the sort of world we live in today which is build upon the idea that you live in the suburbs, commute into the city every day, and take an overseas holiday two weeks per year. If more and more work is remote, we may see permanent digital nomads i.e. rather than commute for hours each day on the freeway or a train and get two weeks per year of travel, you can travel permanently, be on “permanent vacation,” hopping from one country to another and living and working in co-living spaces. This is all very utopian but it may be a reality, and even if it is not a lifestyle most people embrace in the future, it is certainly a lifestyle you can design for yourself once you are financially independent.

Commitment Phobia and Early Retirement as an Escape from Responsibilities

We are well into 2020 now. It is a new year and a new decade. Something that has been on my mind a lot is early retirement. Do I really want to retire early? Once you start earning more, it becomes harder to give up the salary. That being said, work has been hard lately, and whenever work gets hard, I begin to think about early retirement. 

Something that happened in 2019 was that I was in a brief relationship for about three months, but that ended. It was nice while it lasted but it definitely is over, which is a pity because I do want a girlfriend, but I think I do have a severe case of commitment phobia. I am fairly certain I don’t want children, and I could go on forever about the reasons for that, but I am also worried about marriage, which to me seems very risky. I have also witnessed many bad marriages. Many people say that conflict and argument are a normal part of marriage and you need to just work through it, but this seems to be an unsatisfactory answer. For 2020 and beyond, my plan for relationships is the same as always, which is to stay single but be open to meeting new women. 

At this point in time, I am probably as lonely as ever. I don’t think I have any friends. I don’t have a girlfriend either. I pretty much have nothing. Most of my interaction with people is work-related and there are a few people I catch up with every now and then. This is a bit depressing, but at the same time, I do like the solitude. I also like the freedom that comes from just being by myself. It is not like I am completely alone. People do contact me to have lunch or coffee with them, and sometimes I contact others to catch up with them, but mostly these catch ups are not that great. Whenever I catch up with others, I feel like I am just engaging in polite conversation. I cannot really express who I am or what I am thinking. Maybe I haven’t fully built up the courage to say what I want to say.

When I started my financial independence journey, my plan was to retire early in Southeast Asia, and I still want to do this. Whenever times are tough, I’d imagine myself living on a beach on an island in Southeast Asia. I’d sleep in a beach bungalow, wake up late, walk along the sands to a beachside cafe or coworking space, and spend my days reading books or writing books on a laptop, which I would self-publish on Kindle. I’d drink coffee and coconut by the beach while I read or write books. In the afternoon, when the sun sets on the horizon, I could go for a swim, and the water would be very warm.

Part of the reason why I’m hesitant to have children or to marry is because of the threat that children or marriage pose to my early retirement dream. There is something about children or marriage that seems so final. The commitment is so large, and it is a heavy burden. 

When you live differently, people naturally challenge you, and when I tell people about my dreams to retire to Southeast Asia, they inevitably talk about how terrible these places are, how they have poor healthcare, how the traffic is bad, and so forth. All these points miss the bigger picture, which is that the reason why I want to go to Southeast Asia is not beause I necessarily want to go to Southeast Asia but rather it is because I want to have the ability to go somewhere else. Even if I don’t like Southeast Asia, I could always move back or move elsewhere. It is the movement and the flexibility that matters. I want to have no major obligations and I want to be completely free. I don’t want to be shackled to a job I initally liked but have grown to hate as I try to pay off a huge mortgage and car loan. There seems to be a tendency for people to push you to decide on something, commit to it, and then settle down, but I want to keep my options open. I never want to commit and I never want to settle.

How Debt Can be Good

If you simply stand where you are and do nothing, will everything collapse? If so, you need to fix this. If not, you are a free man.

For a long time I have been uncomfortable with debt (see Why You Don’t Need Debt and The Borrower is Slave to the Lender). However, over time, I have borrowed more and more, and I think it is because I have become comfortable with debt. I used a CommSec margin loan to borrow to buy equities, which I now do not recommend to readers because interest rates on a margin loan are approximately 6 percent. I have recently started to use NAB Equity Builder, which allows borrowing to invest in ETFs or LICs for 4.3 percent which is quite low.

One of the problems with debt is that the return on investment needs to outweigh the cost of borrowing. The interest rate on the margin loan is approximately 6 per cent, which means you need to find an investment that beats 6 percent otherwise you will make a loss. However, central banks around the world are lowering interest rates and new products are emerging that allow you to gear into shares with low interest rates (e.g. NAB Equity Builder). Another argument in favour of leverage is that the interest expense is tax deductible. Currently in Australia if you are on a six figure salary, each additional dollar you earn is taxed at 37 percent, so if you are borrowing at 4.3 percent from NAB Equity Builder then after tax you are effectively borrowing at 2.7 percent. In my opinion, 2.7 percent should be easy to beat. As of right now, an ASX200 ETF such as STW is providing 5.66 percent in dividend yield, which after tax is 3.5 percent. Once you add in franking credits and capital gains, you are well ahead.

What about freedom?

One of the arguments used against debt is that debt reduces freedom because you are obligated to pay it. If you have an obligation, this reduces your freedom. However, just as in personal finance we look at both expenses and income so too when considering personal freedom we should look at both obligations to us and obligations from us. While personal finance is about cashflow and net worth, personal freedom is about obligation and specifically whether all your obligations are offset by obligations others have to you. Being free means having as little net obligation as possible.

In a previous post I discussed how freedom ultimately depends not only on cash flow but on “obligation flow.” We all have obligations e.g. the obligation to eat to survive as well as the obligation to put a roof over our head to shelter ourselves. However, if we have enough passive income e.g. from dividend ETFs to cover these costs, we are free, and we are free because our obligations to us (from the companies paying dividends to us) is greater than the obligations from us (to eat and sleep). Basically if your passive income is greater than your living expenses, you are free. It is net obligations that matter.

The same concept applies to debt. Suppose you have an obligation to pay interest. That may not be a problem if you own enough dividend ETFs to cover the cost of the interest. In the example above, the STW ETF’s dividend yield (or a similar ETF e.g. A200, VAS, or IOZ) is enough to cover the interest cost, even after (or especially after) tax.

It is important to keep in mind that dividends are strictly speaking not obligations that companies have. Technically companies do not need to pay any dividends. However, in reality, companies that have historically paid high dividends continue to pay high dividends because of shareholder expectation, and if shareholder expectation does not meet reality, share prices will go down, and the executives deciding how much of company profits to distribute as divdends are usually remunerated with shares, so it is in their interest to ensure the company is both profitable and continues to pay high dividends. Something else to consider is that dividends are not the only form of obligation. A company may use debt to raise capital from bond investors. In this case, there is a real obligation that the borrower has to pay bond investors. Furthermore, going back to shares, companies don’t need to pay dividends to provide value to shareholders. Simply retaining and reinvesting profits back into the business helps the business grow, which increases stock prices. Once the shareholder sells the stocks, there is an obligation to the shareholder to receive the proceeds of the sale. Outside Australia where there is often no franking credits, building wealth through capital gains is much more popular due to tax efficiency.

In summary, holding debt can be consistent with the idea that it is important to minimise obligation because you can have obligation from debt but have it offset with other people’s obligation to you. However, what I should emphasise is that offsetting obligations in this way increases risk. You may have debt to the bank and rely on dividends to pay back the debt, but there is no guarantee dividends will not be cut in the future, and so by playing the middleman game effectively you are taking on risk. The reason why middlemen exist in the world is because of risk transfer. Those on either side of the middleman have transferred risk to the middleman. The same concept applies at work. Middlemen are middle managers who also have obligations from them (to deliver for their manager) but need to match this with obligations to them (from their subordinates). In many areas of life, there is greater risk in aligning these two sides (obligations from you and obligations to you). The key is in if you are able to stomach and manage these risks.

Why financial capital is better than human capital

Obligation needs to be seen not just in terms of money (e.g. debt) but also non-monetary obligation needs to be considered as well e.g. something that takes away your time such as work. Most people go into debt but don’t think about what they need to do to service that debt and so they end up working for the rest of their lives. When I speak about balancing obligations from you and obligations to you, I speak mostly about your financial capital providing income (e.g. dividends) that cover your expenses. However, this ignores human capital. When banks lend you money, they not only look at your financial capital e.g. how much shares or property you have, but they also look at your human capital e.g. your income, job stability, etc.

However, relying on human capital to offset obligation is much more risky than relying on financial capital because income from human capital (i.e. a salary) is active rather than passive. If you borrow to invest and the cashflow is greater than the repayments, there is no obligation from you to do anything. However, if you borrow to invest and you have an obligation to make repayments and if your investments pay low income (e.g. it is a high growth asset) then you top up the difference with your salary which comes from human capital (e.g. your work skills). The problem with relying on human capital is that you are obligated to work in order to derive income from human capital, which reduces your freedom.

In order to take into account non-monetary obligation and to also keep a check on whether you are relying too much on human capital rather than financial capital, I recommend what I call the “do nothing” test. Basically if you do nothing e.g. don’t go to work, don’t take care of the children, etc. If you simply stand where you are and do nothing, will everything collapse? If so, you need to fix this. If not, you are a free man. Even if you have debt, if that debt is being paid for by passive income, it is as if you have no debt. Looking at non-monetary obligations e.g. childrearing, suppose you have children but they are taken care of by a childcare or nanny whose expenses are covered by passive income. You are also free. I have described the “do nothing” test in more detail in a separate post called My Changing Views:

Another key principle I feel I have not let go of is the idea that freedom depends ultimately on the absence of obligation. An obligation is something that compels you to do something in the future e.g. debt compels you to work to pay the debt. Obligation can be non-financial e.g. if you feel you must follow a particular social custom. Obligation is everywhere, and many obligations give people meaning and satisfaction in their lives e.g. obligation to their family or children. However, obligation is indeed the enemy of freedom, so if you want more freedom, you need to minimise obligation. I am a big believer in what I call the “do nothing” test, which is the idea that you are truly financially free when you can do nothing and everything is fine. If you must work to pay the bills, you are not free. There must be automated income coming into your bank account to cover all your obligations.

Can you retire with debt?

Yes, you can retire with debt, but it is harder. For one, you are no longer deriving income from human capital, so you are relying purely on financial capital to pay for debt, which is higher risk not because financial capital is riskier than human capital but because you are drawing down on one type of capital rather than two. It is much harder to get into a job than to get out of a job, so if you need a job suddenly because your financial capital is failing you, there is more effort you need to put in.

A key benefit of borrowing to invest is deducting interest expenses, which is likely to not be necessary or less necessary when you retire because your income will drop.

It all depends on how much risk you are willing to take. The good news is that it is often simple to sell down assets in order to pay off debt. Personally, when I retire, I would not want to keep debt and will simply sell assets in order to pay off debt completely.

Shares vs property

I’d like to end by discussing shares vs property. Most people think borrowing to invest is someting only property investors do. In fact, most people think stock market investors are cocaine-snorting men in suits who perform thousands of trades every day in order to capitalise on small price movements in stocks. In my opinion, shares and property are much more similar than the stereotype suggests. Shares or at least ETFs are safer investments than property because they can hold many different types of assets in them and can provide instant diversification. You can negatively gear into property and you can negatively gear into shares as well. It used to be the case that property allowed you to leverage more because you can borrow to buy property at lower interest rates than with shares (e.g. interest rates for property is around 3% or 4% but a margin loan has interest rates of 6%). However, banks are now starting to understand how similar shares and property are and new products like NAB Equity Builder allow you to borrow at 4.3% which is higher than the interest rate for most property investors (approximately 3.8% as of now) but only slightly higher. Furthermore, banks allow a property to be geared at 80% to 90% LVR whereas NAB Equity Builder allows gearing at up to 75% LVR. Even though LVR is slightly lower and interest rates are slightly higher, stock market investors are not exposed to many of the costs that property investors are exposed to e.g. stamp duty, land tax, and council rates. You also need to factor in franking credits as well as the peace of mind that comes from having a truly passive investment. For a property to be passive, you need a property manager, which eats into your rental income. Furthermore, property is not cheap. The cheapest property you can find in an Australian capital city will likely be about $400k. With ETFs, you can put in $4000 deposit to buy $15k worth of ETFs or you can scale it up. You can dollar cost average with shares but you cannot with property. You are in more control with shares, and when you sell, it can be done within days rather than months and for a much lower cost. Weighing all this up, I think shares are better than property. I would even go so far as to say that you don’t need to buy property at all, even property to live in. Rent is not dead money. If you rent and invest at the same time by leveraging into ETFs (also known as “rentvesting”) you can be better off than if you had purchased a place to live in, and you have much more flexibility to live where you want to live. But that is a post for another day.

Photo by Jamison McAndie on Unsplash

My Changing Views

One of my favourite financial independence bloggers is Pat the Shuffler who has done very well for himself investing purely in Australian ETFs and LICs. He currently has close to half a million in net worth. From what I know, Pat rents a place with his girlfriend, has a high-paying construction job, and manages to save a huge amount of money into Australian equity ETFs and LICs (e.g. VAS and AFI).

However, recently he wrote a post regarding his changing views. Over time, he has realised the importance of global diversification. He will be transitioning away from Australian equities and diversifying into foreign equities using VGS, which invests mostly in the stocks of the US, Europe, and Japan. In my opinion, this is a great move, and it reminds me of my own evolving views, and it has also inspired me to admit some of my own backflips and mistakes.

My views with regards to investing were very similar to Pat’s in that I believed that financial independence depended on dividends alone. If you generate high dividends, you will have enough to live off the dividends and become financially independent quickly. When I read back on my earlier posts (e.g. Dividends vs Capital Gains and 4% SWR vs Living off Dividends), I now notice that I seem quite cultish and stubborn in my views that dividends from Australian equities with franking credits was the only legitimate route to freedom and that anyone who does anything contrary to this is a slave! When I was in my twenties, I would dream of a life in my thirties, forties, and beyond flying around the world, relaxing on beaches, and living off dividends drinking coconut by the beach as I read books.

Perhaps I am becoming more mature as I head into my mid-thirties. I have since relaxed my views on a pure Australian dividend focus. Even though I did invest in some foreign equities, I had the bulk of my investments in Australian equities, and one of the consequences of that as that capital gains were not as high. Had I invested in foreign equities, my net worth today would be much higher. Things may change in the future. I will not tinker too much with my portfolio. For all I know, the Australian stock market may perform very well, but what this illustrates is the importance of global diversification. Australia only makes up 2% of global equities, which is almost nothing, and you never know what policies may be implemented within a country that impacts on every single company in that country.

Another area where my views are changing is in regards to debt and property. I am not a fan of debt, but I do have debt in a margin loan, and if you read my old posts, you’ll notice many posts that are anti-property. Property, in my opinion, is neither better or worse than shares. It is different but also somewhat similar, and there are some benefits of investing in property instead of shares. The key benefit of property is that interest rates on property are typically lower than interest rates for borrowing to invest in shares. Property is easy to leverage and great for capital gains and growth as opposed to Australian shares, which are great for cashflow but historically are lacking in capital gains. Whether now is the right time to be buying property is uncertain. Property prices have been going down for the past two years but the rate of decline has been slowing recently, leading many to believe the market may be bottoming out.

So what do I believe? If I have moderated on everything I have believed in, is there anything here of value? In my opinion, Pat the Shuffler explains it best when he says the following:

“Despite my many stumbles, poor decisions, changing of strategies and general non observance to much of the best advice when it comes to investment, I am still here and still kicking goals. So what gives? Thankfully for me…and everyone else…getting things perfect from the beginning isn’t nearly as important as getting things mostly right and just starting.”

Pat the Shuffler

Basically, it is important to not let perfection get in the way of progress. Most people spend so much time trying to get everything perfect that they don’t start at all. You need to start saving and investing right away, and in my opinion there are three fundamental principles: (1) lower expenses, (2) diversify, and (3) minimise obligation.

Saving a lot of money relies on lowering expenses. Rather than focus on small expenses, we should focus on the big expenses e.g. accommodation and transport. Regarding accommodation, if you live with flatmates or with your parents, you will save far more. Regarding transportion, if you ride a bike or take public transport more, you will save far more. Do you need frequent international travel? Perhaps ride your bike around bike trails in your city.

Another key principle is diversification. Every investment or asset class has pros and cons. Property has cheap leverage and potentially high growth, but poor cashflow; dividend stocks may have less capital growth but good cashflow; tech stocks have low dividends but potentially high growth; gold generates no income and questionable capital gains but may perform very well during a market crash or a period of prolonged economic uncertainty. Rather than feel that you must invest in or feel attached to one asset, it is best to simply diversify across everything. Where there is uncertainty, diversify, and where you feel certain in any asset, it is important ot test that certainty by exposing yourself to the opposite viewpoints. Getting into the habit of challenging our views and diversifying accordingly is a check against our natural psychological biases.

Another key principle I feel I have not let go of is the idea that freedom depends ultimately on the absence of obligation. An obligation is something that compels you to do something in the future e.g. debt compels you to work to pay the debt. Obligation can be non-financial e.g. if you feel you must follow a particular social custom. Obligation is everywhere, and many obligations give people meaning and satisfaction in their lives e.g. obligation to their family or children. However, obligation is indeed the enemy of freedom, so if you want more freedom, you need to minimise obligation. I am a big believer in what I call the “do nothing” test, which is the idea that you are truly financially free when you can do nothing and everything is fine. If you must work to pay the bills, you are not free. There must be automated income coming into your bank account to cover all your obligations.

Reaching Financial Independence under Australia’s Superannuation System and the “Two Bucket” Method

There is a controversy within the Australian financial independence and retire early (FIRE) community about whether to salary sacrifice into superannuation while you are young to get the tax benefits. (For international readers, “superannuation” or “super” is the Australian version of the American 401(k) or IRA, basically a retirement fund.)

When you salary sacrifice into your super fund, the money going in is taxed at 15% rather than your marginal tax rate. For example, if you are earning $100k per year, your marginal income tax rate is 37% so there are large tax savings to be made if you salary sacrifice into super.

However, there is a downside because you do not have access to this money in your super fund until you are 60. For many young people, this is too far away, so they’d rather take the money now.

In my opinion, if you earn under $37k, there are insufficient tax benefits to warrant salary sacrificing into super, but once you earn over $37k, additional income will be taxed at at 32% and 37% so you should be salary sacrificing.

The table below shows that once you earn over about $18k, additional income is taxed at 19% so the reduction to 15% is hardly worth it, but once you start earning over $37k, there is quite a large gain from salary sacrificing.

Australian income tax rates for 2018/2019 and 2019/2020 (residents)

Income thresholdsRateTax payable on this income
$0 – $18,2000%Nil
$18,201 – $37,00019%19c for each $1 over $18,200
$37,001 – $90,00032.5%$3,572 plus 32.5% of amounts over $37,000
$90,001 – $180,00037%$20,797 plus 37% of amounts over $90,000

There are many arguments made not to salary sacrifice into super, and the most common arguments are provided below.

You may need the money while you are young e.g. to raise children, so you should not lock your money up in super

It is important to realise that there is a limit to how much you can salary sacrifice into superannuation. The amount your employer contributes plus the amount you salary sacrifice cannot exceed $25k, so even if you are salary sacrificing into super, there is still money you are not investing in super, so you are likely to have money outside of super to cover any unforeseen expenses.

Futhermore, when most people invest outside of super, they lock the money up anyway, e.g. they buy and hold ETFs or invest in property. It is true that ETFs and property can be sold to be used for necessary expenses, but there is a hassle involved, especially with property. There are large transaction costs involved in unwinding these investments including but not limited to capital gains tax. The only truly liquid asset is cash, and most people hold small amounts of cash to meet day-to-day expenses because they are aware that they can get better returns elsewhere, so why not apply the same principle to supernanuation and lock it up for the tax benefits?

Another consideration is that money locked up in super is still accessible in dire situations e.g. if you are bankrupt and living on the streets, you are able to access money in super via “hardship provisions.”

Another perspective is to look at money locked up in super as an argument for it rather than against it. Many people recommend getting an investment property as an investment because the compulsory monthly mortgage repayment provides “forced savings.” Since property is difficult and costly to unwind, this prevents the average person from raiding the piggy bank to pay for frivolous costs. Super can be seen as the ultimate form of “forced savings” because you cannot access it unless you are 60. Good money management is mostly psychological. Cash in your wallet is as good as gone because there is very little preventing you from spending it at the shops, but money in super is the other end of the extreme, and buying and holding shares or property are in the middle.

Forcing yourself to save money via a mortgage or superannuation is very useful for those who lack self-discipline, and while it is easy to think of yourself as being self-disciplined, most people are not.

Money outside of super can earn more than money inside super. Super is invested in shares and is therefore risky so you should leave money outside super and invest it in safer investments e.g. property.

This is a common argument given, that money in super is invested in shares, and most people perceive shares to be risky, so it is better to not invest in super and invest in property, which is perceived to be safe.

There is so much wrong with this idea. Firstly, most super funds invest not only in shares but also e.g. bonds and listed property. Furthermore, anyone can use a self-managed super fund (SMSF) to invest in almost anything, including Australian residential property (e.g. via BrickX).

Using an SMSF, it is possible to e.g. invest in residential property and even to leverage investments e.g. via internally geared ETFs. There are even margin loans designed for leveraging into super e.g. Nab Super Lever.

Another false assumption is that property performs better than shares. Many equity indexes perform just as well as property if not better. For example, looking at the historical performance of properties on BrickX, the best performing properties average 8% per annum capital gains, but the net rental yield of these properties is about 1.5% per annum. Historical performance of the STW ETF, which tracks the ASX200 index, as of July 2019, according to Bloomberg, also shows 8% per annum capital gains over five years, but the STW ETF also provides 5.93% dividend yield as at writing this, and that is not counting franking credits. If we look at equity indexes such as the S&P500, then performance is even better for shares. One could argue that other equity indexes have not performed well or that particular shares may not have performed well, but the same argument can be levelled at property. The 8% performance for property was plucked from the best performing properties in BrickX. Had you invested in other property, you would not have achieved these results. Furthermore, investing in shares allows you to easily diversify via index funds, and many super funds use either index funds or their active management policies require them to diversify globally, so you are getting instant diversification, but if you buy one house, you are not getting any diversification at all, which is a huge risk.

Furthermore, the argument that shares are riskier because they are more volatile is also false. The reason why stock prices move up and down quickly is because shares or ETFs are listed on the stock exchange. The price is disclosed whenever the market is open, which is every weekday. However, we only learn about the price of property when we buy or sell it or when we have an auction, and this happens very infrequently, e.g. every ten years. If there is an auction for a particular house every single day, there will be price volatility. Because there is not an auction every single day, this hides the volatility, but it doesn’t mean it doesn’t actually exist.

The fact that house price volatility is hidden also hides losses very well. For example, one of my friends had a mere $10k in his superannuation fund, and during the GFC his balance went down by $4k. He was so freaked out seeing the balance in his fund reduce so much so quickly that he withdrew all the money. He is an old man, so he is able to do this. However, this friend also owns a property that is valued at about $1 million, and in the recent 2017 and 2018 property price declines in Australia, the valuation of his property using CoreLogic data shows that his property went down in value to $800k, so basically $200k was wiped out, and he didn’t seem fussed at all. When my friend saw $4k wiped out from his super fund, he saw the balance go down instantly. He saw the market gyrations on the financial media and the stock market charts in free-fall. A mere $4k loss was enough to freak him out. However, when $200k is wiped out from his property, he doesn’t bat an eyelid. He knew in general that property prices were going down, but there is no dramatic price charts, and it is often uncertain to really know how much your property is worth. Most people have no idea. This story illustrates how irrational most people are with regards to property vs shares.

The government may change the rules and start taxing your super heavily.

This is another common argument against superannuation, that if you put your money in super, it is at the whims of government legislation. Supposedly if your money is locked in super, there is temptation for the government to increase taxes on super or increase the age at which you have access to it.

However, the problem with this argument is that even if you don’t put your money in super e.g. you put it into property or shares outside of super, it is also at the whims of government legislation changes e.g. if there are changes in income tax, capital gains tax, or franking credit legislation. Government can change anything, not just legislation that impacts on superannuation but also legislation that impacts on funds held outside of superannuation.

The only way you can avoid the risk of rising taxation imposed by the Australian government is to move your money into offshore havens or to e.g. cryptocurrency such as bitcoin, ether, or monero. However, offshore havens are not immune from the risk of legislation change. If your money is held in e.g. Bermuda, who is to say the Bermuda government can’t change its legislation? Cryptocurrency is also not a foolproof tax avoidance mechanism since crypto is still subject to capital gains tax by the ATO. There are other risks with crypto as well because even if you avoid countries and government, arguably the country or government in a crypto investment is the community of investors or the miners and the legislation is the protocol that governs how the crypto operates, and this is subject to change by developers. A whole book can be written about this, but basically there is no way to avoid risk of changes in legislation negatively impacting investments unless you diversify.

Contributing to super prevents you from retiring early

This argument is somewhat true but not as bad as you may think. Basically if you salary sacrifice into super, you don’t get access to the funds until 60, so if you are putting a huge amount into super, you may have enough to retire early but you don’t have access to it, which means that effectively your early retirement is deferred. To take an extreme example, suppose you need $1 million to retire, and you salary sacrifice so much that you have $1 million in super but nothing outside of super (because you use all your cash outside super to spend on expenses). Then you cannot retire until you reach 60 even if you managed to amass $1 million in super by e.g. age of 40.

However, as I stated before, there is a limit to how much you can salary sacrifice into super. The employer contribution plus amounts salary sacrificed cannot exceed $25k per year, so more realistically the amount you save outside of super should roughly equal the amount going into super. Rather than reach the age of 40 with $1 million only in super, chances are you will have $500k in super and $500k outside super. The amount outside super will likely be in e.g. ETFs, shares, and property.

Early retirement according to the FIRE community relies on the “four percent rule” i.e. your annual expenses should equal 4% of your net worth. If you reach age 40 with $1 million in your super, you cannot retire early and spend $40k per year because you don’t have access to the funds, but if you reach age 40 with $500k in super and $500k outside super, you probably can. Simply take the age at which you can access your super and subtract it by your age. In our example of someone retiring early at 40, this means there is 20 years left before he or she has access to super at age 60, so the money outside of super of $500k needs to last for 20 years. The simplest way to make sure you don’t spend over $500k in 20 years is to apply a simple straight line calculation and divide $500k by the years left, so in this case $500k divide by 20 is $25k per year you should spend before you have access to your super fund. By the time you have access to your super fund, that $500k in 20 years should be about $2 million assuming 8% per annum growth, and this means by the time you reach 60 you can apply the four percent rule and draw down $80k from your super per year. This is what I call the “two bucket system” and it is briefly explained by Aussie Firebug in his Australian Financial Independence Calculator as well as Mister Money Moustache in his article How to Retire Forever on a Fixed Chunk of Money.

Of course, retiring early on $25k and then suddenly reverting to $80k after 60 is a very weird way of implementing the two bucket method because I use a straight line method to draw down funds before access to super and then after access to super I use the four percent rule. Ideally you should use the four percent rule both before and after age 60 and arrange it such that you run out of pre-super funds just as you hit 60. This requires a much more complicated formula that Aussie Firebug has worked out in his spreadsheets above, but I believe that using the straight line method before access to super is much easier. The straight line method ignores growth in the pre-super funds, and so it is very conservative.

If you salary sacrifice heavily and use the straight line method to draw down funds before access to super, you will likely push early retirement out a little. If you are not willing to do this eg if you are absolutely determined to retire at age 40, then one way to still retire early while also salary sacrificing into super is to temporarily retire in a low-cost-of-living (LCOL) area e.g. Southeast Asia and then come back to Australia when you are 60 to access your super and retire here. The benefit of this approach is to use geoarbitrage to get the most bang from your buck in a LCOL area while you are young but then come back to a welfare state to access generous healthcare systems when you are older. However, this will be the subject of another post where I speak in more detail about retiring in LCOL areas as well as the “two bucket” system.

Thoughts about the 2019 Australian Federal Election

In my previous post (How to Adapt to the Labor Party’s Reforms to Franking Credits) I spoke about how to adjust your portfolio if Labor won the 2019 Australian federal election. The polls and the betting odds were showing a Labor win, but remarkably the Coalition won, so everything is business as usual. I will admit the result came as a huge surprise for me and although I did not vote for the Coalition, I accept the will of the people as this is a democracy.
I have mixed feelings because personally I imagine I will benefit from the Coalition’s policies e.g. cash refunds from franking credits as well as capital gains discounts and reductions in the top tax rates down to 30%. A large portion of my wealth (maybe 70%) is in Australian shares. The focus of the election was on the property market and in particularly on negative gearing, but negative gearing does not impact me because I positively gear into stocks. Leveraging into high dividend shares to get franking credits usually results in a positive gearing position because the dividend income typically exceeds the interest expense.
Something that bothers me and makes me feel some sense of guilt is that I understand that more money in my hands to live off dividends means there is less money for others. Some may flippantly say that if I want to fund these programs, I should do so with my own money, but welfare is not sustainable without taxation. Medicare, for example, would never work if it relied on private donations.

Labor proposed a number of policies that would have helped the poor, the sick, and the environment e.g. subsidised dental care, subsidised treatment for cancer patients, subsidised childcare, and funding for climate change action. That many people would vote for money to be given to investors to leverage or gear into the property and stock markets and live off dividends rather than fund these other worthwhile causes is, in my opinion, quite disappointing because it reveals something quite negative about human nature. It is yet further evidence that human nature is darker than I imagine. I am not naive, but I do wrestle between wanting to belive that humans are inherent good vs inherently bad, and it seems that every day there is a stream of evidence that points towards the the idea that humans are innately bad.

Many people think I am lame for thinking this way. My father tells me I should forget about others and think about myself. He constantly tells me I need to “man up” and get married, have children, etc. However, when I think about human nature, it makes me think about whether I should have children or whether I should start a family. With childcare costs rising and with climate change presenting an existential risk for the next generation, does it make sense to have children? If people are truly bad, what sort of world would my child inherit? What sort of social ills would my child be faced with?
I am still childfree and single but haven’t ruled out a relationship, marriage or children, but I am not the sort of person who would just jump into something big without careful consideration.
The way I see it, there are two options. One is believing in the goodness of humanity and instilling these positive values in my child so they grow up and contribute to a positive society and world. Financial independence becomes a means of funding procreation, and procreation is pursued for the sake of perpetuating the human species because the human species is good.
The other option is to believe that humans are inherent bad, and in this case financial independence plays a defensive role with passive income used to retire early and to shield myself from society.

How to Adapt to the Labor Party’s Reforms to Franking Credits

According to the Sportsbet odds, there is a very good chance that the Australian Labor Party will win the next election, and there are a number of proposed policies that will have a large impact on investors.

Sportsbet odds as of 6 April 2019 have Labor winning the next Australian federal election

I don’t want to focus too much on my personal political views as I feel I should only discuss personal finance here, but personally, even if I benefit economically by voting for the Liberals, there are many other non-economic issues that bother me about the Liberals e.g. it is highly likely that there is a Nazi faction within the Liberal party. This raises the likelihood that the Liberals will engage in Trump-style divisive politics based on racism and sexism. Furthermore, something I care about more than money is the environment, and the Liberals are filled with climate change skeptics.

Back to the topic of personal finance, one proposed Labor policy is banning refundable franking credits. This has mislead many people who think that franking credits will be banned. In order to understand what this policy is, it is important to understand what franking credits are.

Australian companies pay a corporate tax rate of 30% on their profits. A portion of the profits is then distributed to to shareholders as dividends. However, when shareholders receive dividends, they pay tax on their dividends. As a result, there is “double taxation” i.e. the company pays taxes on profits and then the shareholder pays income tax. To fix this problem, when companies pay dividends, they can attach franking credits to it, which allows the tax paid by companies to be refunded back to the shareholder.

Companies pay 30% corporate tax, but shareholders pay income tax, and given that there is progressive taxation is Australia, shareholders may pay anywhere from zero tax to 45% tax depending on their income. The higher your income, the higher your income tax rate. If you are on the highest income tax rate of 45% then the franking credits that refund the 30% corporate tax back to you will not cover all your taxes and you will still need to pay money to the government. However, there are many people who retired who have low income and live off dividends. Because they earn little, they may pay zero income tax, but because dividends have franking credits, they are in a position to receive money from the government. It is these cash refunds that Labor is targeting, not franking credits in general.

How to adapt to the new policy

Franking credits do not apply to all investment income. For example, income from property has no franking credits e.g. REITs. Furthermore, income from outside of Australia e.g. US equity ETFs such as IVV pay dividends with no franking credits.

In order to adapt to the new policy, simply increase the amount of unfranked investment income you receive. Once the amount of unfranked investment income increases, the income tax you pay will rise. Remember you only get a cash refund when your personal income tax is below 30% so if you increase how much unfranked investment income you receive such that your personal tax rate is at or above 30% then any franking credits you receive will simply offset the taxes you pay on the unfranked income you receive, so you don’t need to worry about receiving a cash refund.

As I said, the easiest way to achieve this is to invest not just in Australia but to go overseas and invest outside of Australia. Examples of ETFs that achieve this are VGE (as well as the ethical equivalent VESG) as well as INCM, which is globally focused equity income ETF. Another option is to invest in AREITs e.g. SLF, which invests mostly in Australian commercial property and pay quite high rental yields.