FIRE – I Live Off Dividends

Is Investing in Crypto Irresponsible? A Cake and Icing Analogy for Investing

“He is richest who is content with the least” ~ Socrates

Recently I have been thinking about Tesla’s decision to invest $1.5 billion in bitcoin and accept payment for Teslas in bitcoin (although later Tesla stopped accepting payment in bitcoin due to environmental concerns).

This decision by Tesla as well as many other companies to invest in bitcoin made me think about the decision. Bitcoin is considered a very volatile asset and so it made me wonder about the merits of companies buying bitcoin. Many businesses are also considering pricing their goods or services in cryptocurrency, but this presents challenges due to the aforementioned volatility of crypto.

After much research, it seems many companies were buying bitcoin as a replacement for idle cash on their balance sheet. All companies have a bunch of assets on their balance sheet related to the normal operations of their business e.g. Tesla would have factories as well as patents on their balance sheet as assets, but companies also need to hold liquid assets such as cash in order to meet expenses. For example, Tesla needs to pay taxes, and taxes are denominated in currency like USD, and so Tesla needs to have USD on hand to be able to pay for these expenses.

Through research, I found that the $1.5 billion in BTC that Tesla had only represented about 8% of its cash. This means that Tesla had about $19 billion in cash and it has converted a small amount of that into BTC.

How does this relate to individuals and early retirement?

Individuals are similar to organisations. In the same way that Tesla holds cash to be able to meet expenses, so too I hold a small amount of cash as well. In the same way that Tesla keeps most of its assets in its business e.g. factories, so too I keep most of my assets outside of cash. The reason why I don’t want to hold too much cash is because cash does not earn much. In fact, given that savings accounts provide virtually no interest, cash does not really earn anything, especially when you factor in inflation. It makes sense to keep most of your net worth in higher returning assets while only keeping a small amount of your net worth in cash in order to meet expenses.

We need to take on more risk to beat inflation

We don’t keep all our net worth in cash because we need to beat inflation. Everyone has expenses and these expenses are denominated in the local fiat currency. For example, for someone living in Australia, they’d need to pay taxes, which are denominated in Australian dollars (AUD). The necessities of life such as food and shelter are also denominated in AUD. According to Numbeo.com, as at May 2021, the cost of living in Melbourne, Australia for a single person is $1322 per month not including rent. The cost of rent is $1715 for a one-bedroom apartment in the city. This adds up to $3037 per month or $36444 per year. If we round this up to $40k and then apply the 4% rule, this means you will need $1 million in net worth to be able to retire in Melbourne.

The 4% rule assumes a rough mixture of stocks and bonds, approximately 50% in stocks and 50% in bonds, which can be acheived with a balance ETF. An example of a balanced ETF with 50% bonds and 50% stocks is the Vanguard Diversified Balanced Index ETF (VDBA).

Basically if you have $1 million and put it into VDBA, you’d be able to live a comfortable life in Melbourne, Australia.

Icing on the cake

But what if you have more than $1 million? Suppose you have $2 million in net worth and you have $1 million in VDBA from which you are drawing $40k per year to meet basic expenses. Because the other $1 million is not necessary for covering basic expenses, why not invest it in higher risk investments e.g. a high growth ETF such as VDHG or even in a diversified basket of cryptos? You can divide this $2 million wealth into two parts: VDBA, which represents moderately volatile investments needed to meet basic necessities denominated in local fiat currency (i.e. the cake); and crypto (or VDHG), which represents more volatile investments that provide extra income (i.e. the icing on the cake).

Volatility is relative depending on the base asset

No asset is inherently volatile. One of the main criticisms of cryptocurrency is that it is too volatile. Let’s take a crypto such as ether (ETH). ETH is volatile if priced in USD. However, if you price USD in ETH, suddeny USD looks volatile.

When most people thinking about volatility, they think about volatility relative to the local fiat currency, and the reason why they think this is because most good, services, and taxes are denominated in that local fiat currency. If I am living in Australia, I need to pay for rent, food and taxes with AUD, so I need to make sure that the $1 million I hold in my “cake” fund is not too volatile relative to AUD, which is why you would hold it in VDBA or similar. However, if I can meet rent, food and taxes with $1 million in VDBA and I have more, why do I need to worry about volatility priced in AUD? Why not increase volatility to the maximum level once you can cover your basic expenses?

Age-based vs wealth-based bond tent

A very interesting idea proposed by Michael Kitces is the idea of creating a “bond tent” to mitigate sequence of return risk.

Sequence of return risk is basically the risk of a severe market crash occuring right after you retire. So imagine you have 100% in equities and it is 2008. You finally amass $1 million in wealth and decide to retire. Then suddenly the GFC happens and the stock market falls 50% thereby reducing your net worth to only $500k.

Dampening The Volatility Of The Portfolio Size Effect Using A Bond Tent — Figure 1: Michael Kitces’s Bond Tent

The bond tent addresses this risk. Basically, in order to create a bond tent, before you retire, you gradually increase the proportion of your net worth in bonds. Then when you retire, you reduce it. The reason why you reduce your bond allocation after you retire is because, according to the theory, you need equities for long term growth. Bonds provide stability but not growth. The risk with holding too much in bonds when you are retired is that you have stability at the expense of not enough growth, which increases the risk you deplete your wealth before you die.

However, I think there is a problem with the bond tent. If you look at the horizontal axis above in figure 1, you’ll notice it is based on age. You retire at 65. At that age, the bond allocation is at its peak. Why should this be based on age? Why not make it based on wealth?

As I’ve described previously, you need about $1 million in about 50% stocks and 50% bonds to retire and live a modest life. Why not change the bond tent chart above by replacing the horizontal axis with net worth? The peak of the bond tent should instead occur when net worth is $1 million. This means that when you are young, you should take on more risk because, even if the market goes down, you are still young and have time to earn money to replace money lost. However, as you gain more wealth, the risk grows because you have more money exposed to riskier assets and you are close to the net worth required to cover your necessary expenses. Imagine you are 25 and have $100k in net worth and suddenly the GFC occurs. Then you’d lose $50k. However, you would be able to replace this loss with one or two years of work and savings. However, imagine you are 35 and have a net worth of $1 million and a GFC happens. Then you’ve lost $500k. This loss could take about 15 to 20 years to replace, which sets back your early retirement considerably.

The importance of minimalism

The wealth-based bond tent illustrates to us the importance of minimalism and how it can help you build more wealth. The $40k per month expense is based on Numbeo’s estimate of expenses of a typical person. However, suppose someone is able to live on less. Suppose hypothetically someone can live off $20k per year e.g. rather than retire in Melbourne, Australia they are happy to retire in an area with a lower cost of living. Perhaps they are willing to live in a one-bedroom apartment on the outskirts of the city rather than in the city itself. Regardless of how someone saves money, if you are able to get by on $20k per year, then the bond tent shifts to the left. You only need $500k in VDBA in order to create the “cake” needed to cover your living expenses, and once you hit this $500k net worth, you can quickly put any new money into the “icing” fund, which goes into high risk assets, which provide opportunity for higher returns (and losses).

Imagine two people who earn $100k per year. One is a minimalist who spends only $20k per year vs a normal person who spends $40k per year. The person who spends $20k per year is able to invest $80k per year (assuming no taxes) and is able to accumulate $500k within 6.25 years (for simplicity, assuming no investment growth). However, the normal person spending $40k per year is only able to invest $60k per year which means they will need 16.66 years in order to accumulate $1 million.

By being a minimalist, you are able to overtake the bond tent more quickly and transition your wealth into higher risk assets at no risk to your retirement because you have already built a solid foundation i.e. you have fully developed your “cake” fund and are now simply putting the icing on the cake.

A minimalist who can live off $20k per year is able to provide themselves with financial independence within 6 years and in their seventh years they can invest in higher risk assets such as more speculative tech stocks or ETFs or cryptocurrency. However, a normal person who lives off $40k per year needs to wait 16 years before they can do this.

Lifestyle inflation destroys the icing

A normal person living off $40k needs to invest for 16 years before they can be financially secure or independent, but imagine if that normal person, after 16 years of hard saving, suddenly inflates their lifestyle such that they spend $60k per year. If after you have $1 million you suddenly have $60k worth of spending, then this means $1 million is not enough. According to the 4% rule, you now need $1.5 million, which means you need to save up $500k more, which means you need to work 8 more years in order to build up your “cake” fund.

By inflating your lifestyle, the cake needs to grow, which means you spend more time investing in VDBA or similar assets. Your opportunities for higher growth are impaired because you’re forced to invest in safer assets for longer in order to fund your lifestyle inflation.

Cake spending vs icing spending

What does lifestyle inflation mean? In my opinion, lifestyle inflation occurs only when your necessary ongoing expenses goes up. Suppose you have $1 million in VDBA generating $40k and this goes into food, shelter and taxes. This is the “cake” and your spending on food, shelter and taxes are what I call “cake spending” because these are necessary ongoing expenses. You cannot avoid food, shelter or taxes otherwise you will die or be put in prison.

Let’s suppose you have another $1 million in crypto and you draw out 4% from this for spending. This is the “icing” but you need to spend it on what I call “icing spend” which are unnecessary once-off or reversible expenses.

So a person with $1 million in VDBA and $1 million in crypto draws $80k. $40k goes into food, rent and taxes, but the other $40k can go into a lavish holiday. A holiday is not necessary, once-off and not ongoing. This is important because the icing fund is high risk. Crypto is highly volatile and could drop by 90% within a year. Suppose this did happen and the $1 million in crypto suddenly turns to $100k. Then rather than within $40k in icing expenses you are withdrawing only $4k in icing expenses. This is not a problem because you simply take a cheaper holiday or don’t go on holiday at all. The icing is optional. You don’t have to eat a cake with icing.

An example of ongoing necessary expense beyond food, shelter or taxes is, for example, if you decide to have a family. Paying for a family means added ongoing and necessary expenses e.g. food, shelter, childcare, etc. If crypto prices suddenly fall and you can only draw out $4k per year rather than $40k per year, this is not going to be good if food, shelter and childcare prices are higher than $4k per year. However, a holiday is not necessary and can be scaled back if required.

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 thresholds	Rate	Tax payable on this income
$0 – $18,200	0%	Nil
$18,201 – $37,000	19%	19c for each $1 over $18,200
$37,001 – $90,000	32.5%	$3,572 plus 32.5% of amounts over $37,000
$90,001 – $180,000	37%	$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.

Property Prices Decline in Melbourne and Sydney – Should I Buy?

After property prices have been going up for quite some time, there seems to be a considerable amount of anxiety in Australia as house prices start to fall. According to Corelogic, so far there have been price declines of about 10% in Sydney and Melbourne. However, this is an average and masks the finding that top-end properties have been declining much more than affordable properties e.g. the average Broadmeadows house in 2017 is $540k and in 2018 it is $560k, a slight increase. However, in Toorak house prices went from $5 million 2017 to $3.4 million in 2018, which is a 30% decline and $1.6 million wiped out of the average Toorak house.

Toorak house and unit prices as of February 2019, source: realestate.com.au

If you own a home, does this mean it is a good time to sell it? Alternatively, is it a good time to buy?

My answer is that I don’t know. In my opinion, it is rarely a good idea to try to time the market as studies show that most people fail to pick the bottoms and the tops. The better strategy is diversification. One form of diversification is diversification into different types of assets e.g. splitting your wealth across e.g. stocks, bonds, property, gold and cryptocurrency. However, with property there is little opportunity to diversify because each house is very expensive. The average family home in Melbourne costs about $800k. If you save up a 20% deposit of $160k and right after you buy there is a price decline of 30%, then you’ve lost $240k. Another major problem with expensive property is limited ability to dollar cost average. In a volatile market, you can invest a small amount every fortnight to smooth out the bumps, but this is clearly not possible if you’re borrowing to buy a house.

Will I buy a property?

I have been anti-property for a long time, preferring instead to live at my parents and invest in ETFs. My plan was to live off dividends and eventually use the dividend income to rent a place. When my dividend grew high enough, I’d retire early and travel the world forever, living in Southeast Asia. This plan was hatched during a time when I hated my job.

However, as my salary and dividend income rise, I am having mixed feelings about gallivanting in Southeast Asia for the rest of my life, especially when I am starting to enjoy my work, and I’ve realised that although renting can be cheaper in some suburbs, this does not apply to all suburbs. In many suburbs, it is cheaper to rent, but there are some suburbs where it is cheaper to buy. This depends on a number of factors e.g. rental yield but also how much you earn. The more you earn, the more likely it is that it is cheaper to buy rather than rent. This is because you rent with after-tax income. For example, if you paid zero tax, then if you had a choice between buying a $1 million apartment or renting it for $40k per year then it is preferable to rent because you could invest $1 million in an Australian equity ETF or LIC (e.g. A200, VAS, BKI, or ARG) and earn about 5% dividend yield of $50k per year, use the $40k to rent and have $10k leftover. However, if you were earning enough salary such that you are taxed at 40% (if you earn over $80k then you pay 37% in income tax in addition to a 2% medicare levy so it is approximately 40%) then rather than getting $50k in dividends you’d only be getting $30k after-tax (ignoring franking credits), which is not enough to pay the rent of $40k per year. In this case, it is cheaper to buy.

Although this may vary across different cities, as a simple generalisation, within Melbourne family homes tend to be cheaper to rent whereas units and apartments tend to be cheaper to buy. For example, using Toorak again as an example, the average Toorak house costs $3.43 million whereas it costs $965 per week (about $50k per year) to rent. If you had $3.43 million to afford a home, you’d be better off putting this in an ETF earning say 5% dividend yield of $171k per year. Even after tax and ignoring franking credits you’d have about $16k per year in dividend income. You’d then pay the rent of $50k and have $66k per year extra if you rented.

Home prices vs rent prices in Toorak as of February 2019, source: realestate.com.au

However, this does not apply if you are buying or renting a Melbourne CBD unit (which is where I’d rather live). A unit in the CBD is $484k to buy and $530 per week ($28k per year) to rent. Putting $484k into an ETF earning 5% dividend yield would only give you $24k before tax, which is not enough to afford the $28k rent. Given that it is cheaper to buy ignoring tax, it will definitely be cheaper to buy after tax. The higher your marginal tax rate, the more likely it would be that buying is cheaper. However, this analysis ignores the high body corporate fees that apartment owners typically pay. Furthermore, an argument can also be made that Toorak homes are better investments vs CBD apartments. Therefore, it may be worth buying a Toorak home vs an ASX200 ETF as there is some hope that the Toorak home will outperform the ASX200 whereas there is little chance a CBD unit will outperform the ASX200, and this may explain the differences in rental yields.

*Melbourne CBD buy vs rent prices as of February 2019, source: realestate.com.au*

Arguments for home ownership

As I said, I am considering buying a place of my own. One of the reasons is that I am starting to dislike commuting and would rather walk to work. Another reason is that over time I am starting to dislike living with my parents. Furthermore, buying a place is not that inflexible. Even if I move, retire early, or even dislike the place I live in, I can arrange for a real estate agent to rent it out the apartment and forward any leftover rental income to me, so I can still retire early and live off rental income, although rental income will likely be lower compared to dividend income because the real estate agent will take a cut of the rental income as a fee for managing the property. Furthermore, rental yields are typically lower than dividend yields.

Another concern with buying a property is debt. I believe that it is important to always be ready to retire because you never know when you’ll be fired or if you’ll hate your job. Buying a property usually incurs significant debt, and many people are tied to their jobs because of the mortgage. However, even though I own ETFs now, I still have a small amount of debt via a margin loan. I rationalise this by telling myself that the interest expenses is tax deductible and also in the event of a need to retire early I can easily sell off ETFs to pay off all the debt. This idea can be applied to property as well. If you buy an affordable property (e.g. $300k to $400k) and save up a large deposit (e.g. 50%) before you buy, even if you are fired you can sell the property and invest the proceeds into high dividend ETFs. Another alternative if you have enough equity in the property is to simply rent it out. If the equity is high in the property, the rental income should be higher than the interest cost as well as property management fee, which makes this a passive income stream similar to dividend ETFs.

Another option is to sell all my ETFs and buy a place outright, but I’ve decided against this idea because then I’d forego dividend income as well as trigger capital gains tax. When I buy ETFs, my plan is to hold it forever. Ideally, I’d like to hold any asset I buy forever and live off investment income (with the obvious exceptions being gold and cryptocurrency).

Conclusion

In my opinion, the best test of financial independence is to ask yourself how long will you survive if you have no job. If the answer is “forever” then you are financially independent.

Right now, in my thirties, I generate about $20k per year in dividend income, which in my opinion is enough to live a reasonable lifestyle in Southeast Asia e.g. Bangkok, Chiang Mai, Bali or Sihanoukville. If I really hated my job now or if I were fired, I could fly to Southeast Asia, live there for a few decades, and then come back to Australia to collect my superannuation.

However, even though I feel I could do it, I don’t feel comfortable relying solely on $20k per year in dividend income, and as I said, even though I hated my job many years back, I am starting to enjoy it more and more, so my plan is to stay in Australia and continue to invest and build more dividend income. However, if my plan is to stay in Australia for longer, I’ll need to consider my comfort, and two areas of discomfort in my life now are living with others and commuting. Basically being around other people bothers me. If I live with others, I have little privacy, and if I am on a packed train, it bothers me as well. Being at work with others bothers me if I am around the wrong people. The key is in having enough financial independence to allow you to have more say or control over the type of people you surround yourself with. Something I have learned about myself is that I am very much a people person. If I am around the wrong people, I feel extremely unhappy and depressed, but being around the right people can make a huge difference to your mood.

Buying a place in or close to the city will cut my commute, allowing me to walk to work, and it will also allow me to live by myself. If I save up enough cash deposit and buy a reasonably cheap place, even if I do decide to retire early, I’d still be able to “positively gear” the property by renting it out and generate passive rental income, which when coupled with my dividend income can boost my early retirement living standards.

Is Salary Sacrificing into Super Worth It?

Because I live in Australia, there are some financial ideas that are unique to Australians e.g. franking credits, negative gearing, and superannuation.

Firstly, what is superannuation? Superannuation (or super) is a retirement fund similar to the US’s 401k. When your employer pays you, they are required by law to put 9.5% of your salary into your super. This super is locked up until you are old (about 60 to 70).

Why salary sacrifice into super? Compared to many other countries, income tax is high in Australia. Any amount you earn over $37k has a 32.5% income tax rate applied to it. If you earn over $90k then any amount over $90k attracts a 37% income tax rate. However, suppose you earned $100k per year and you arranged with your employer to salary sacrifice $10k into your super fund, then this means that rather than paying $3700 tax on that $10k and receiving $6300 in your bank account, you instead have that $10k go into your super fund and where it is taxed at only 15% i.e. you pay $1500 tax. This means you save $2200 per year assuming you salary sacrifice $10k per year.

If the tax benefits are so good, why not salary sacrifice everything into super? The answer is that there is a limit. The amount your employer puts in (9.5%) and the amount you salary sacrifice cannot exceed $25k per year. Take the example of someone who earns $100k. This figure does not include super. The employer is paying $9500 (9.5% of $100k) per year into superannuation by law. However, if the worker wants to top this up by salary sacrificing, they should simply find the difference between $25k and the compulsory contribution amount ($9500) and then salary sacrifice this amount. In this case, the person earning $100k should salary sacrifice $15500 per year to fully take advantage of the tax benefits. If you get paid every fortnight, simply divide this by 26 and therefore salary sacrifice $596 per fortnight. In my opinion, you should always salary sacrifice a little bit below the limit because your salary will likely increase bit by bit over time. If the amount you salary sacrifice is exactly $25k then the next salary increase (e.g. due to inflation correction) can tip you over the $25k mark, which leads to punitive taxes applied to you. Therefore, I recommend aiming for $23k or $24k just to be safe.

Using the example of earning $100k per year, if you are salary sacrificing $10k per year you’d save $2200 per year. If you salary sacrifice to the max then you’d be making $3410 per year.

Assuming you save $3410 per year over 30 year, then assuming 8% per annum returns, you’d have $250k.

What are the downsides of salary sacrificing into super?

Even though there are tax benefits, the main disadvantage of salary sacrificing into your super fund is that you do not get access to this money until you are around 60 to 70. However, there are hardship provisions in superannuation that allows you to access your super under severe financial hardship. Given that I am a long-term investor, I normally buy and hold investments forever. I will only ever sell if there is severe financial hardship. Therefore, keeping money in super doesn’t make much difference. For most people who do not salary sacrifice into super, their main reason is that they need to pay the mortgage, but they are simply building up savings in their house, and because houses have high transaction costs, chances are they will only sell the house under severe financial hardship as well.

One common argument people use against superannuation is that the “rules can change.” That is, while your money is locked up in superannuation, the government could change the rules and e.g. increase taxes on it. However, this is not a good argument. The risk of government changing rules or legislation apply to all investments. For example, if you do not salary sacrifice and invest in property and shares outside of super, the upcoming proposed changes to negative gearing, capital gains tax and franking credits will affect you. Unless you invest in offshore accounts or cryptocurrency, you are at risk of “rules changing,” and even if you invest in, say, offshore accounts, then offshore jurisdictions are subject to changes in legislation, and cryptocurrency protocols can change, leading to “hard forks.” You can never escape the risk of legislative or protocol amendment. The only way to mitigate this risk is to diversify.

The key downside of salary sacrificing into super is that you do not get passive income, which impacts on your ability to be finacnially independent. If you salary sacrifice $10k into super, that $10k does not produce dividends that go into your bank account for spending. It simply accrues in the super fund and accumulates until you are, say, 60. This means that if you seek to be financially independent quickly or retire very early, salary sacrificing into super can be a problem. However, there are workarounds.

The four percent rule

The four percent rule states that when you retire you spend 4% per year. Suppose you retire with $1 million in net worth. You simply spend $40k per year. Now suppose you had $500k in super and $500k outside super. One strategy is to continue to use the 4% rule but to retire at a time such that you can use the 4% rule and then time it so that you run out of your $500k outside of super just before you have access to superannuation.

Coast FI or Barista FI

Another option is called “coast FI” or “barista FI” which are terms used among the online FIRE community (financial indepence retire early). Basically you can salary sacrifice to the max early in your career such that you have, say, $200k in super by age 30. Assuming 8% per annum growth, then this $200k in super will become $2 million by age 60 assuming no extra contributions. Therefore, through aggressive early savings, your 60s are covered. Having $2 million when you are 60 is more than enough. However, because you have locked up a considerable amount of money into super, you may live a lower standard of living up until you are 60.

One solution to this suggested by the FIRE community is “coast FI” which sadly has nothing to do with the Gold Coast. Rather, you coast to your 60s by taking it easy and doing easy jobs (e.g. a barista, although based on what I have seen being a barista is quite difficult). However, in my opinion, this is not a good strategy because even easy work is still work, and there is no guarantee that you will be able to find easy work in the upcoming age of automation. The whole point of financial independence is to enable you to live without a job so that you can pursue whatever you are passionate about.

Although there are problems with barista FI, the insight that barista FI brings up is that you don’t need to retire early. Once you live off dividends, rather than retire and stop working, you can keep working but simply don’t work as hard. You don’t need to work as a barista, but you can work the current job you work but simply work in a more relaxed manner. This may mean you spend more time at work chatting to coworkers or it may mean you work part-time and take more holidays. A more mainstream term for this is “semi-retirement.” Another option is to change jobs and do something you are passionate about e.g. you may build online social enterprises that help the world.

The solution to the superannuation dilemma

Superannuation presents many Australians with a complicated dilemma. Either you salary sacrifice and increase your wealth thanks to tax benefits but lock your money up unitl you are very old, or you do not salary sacrifice, reduce your wealth, but reach financial independence faster.

In my opinion, you should salary sacrifice to the max early in your career. However, to accelerate your chances of becoming financially independent as fast as possible, live as minimalist a life as possible (e.g. living with roommates or with parents, riding bikes or taking public transport, never having children, etc) and then with your money outside of super apply the Peter Thornhill approach by investing all your money into high dividend paying Australian equity ETFs and LICs (e.g. VHY, IHD, RARI, EINC, RINC, BKI, AFI, and ARG). Because Australian equities are blessed with high dividend yield and franking credits, this coupled with a highly minimalist lifestyle will allow you to quickly achieve financial independence. To use some example numbers, the cost of a sharehouse found via Gumtree or Facebook is about $700 per month. The cost of meal replacement drink Aussielent (which I use as the basis for the cost of food) is $256 per month. Then if you get a bike then you can cover all necessities for $1000 per month or $12,000 per year. Assuming dividend yield of 7% then this means you need to save up $170k. Adding income tax and offsetting it with franking credits, this means you’ll only need to save up about $200k in high dividend ETFs or LICs to be able to be financially independent. After you have $200k, you can start to diversify your portfolio away from Australian equity to reduce risk (e.g. into bonds and international equities). Then over time, as your dividend income increases, you can slowly increase your living standards, e.g. live by yourself rather than with housemates or parents. You can eat tastier food rather than Aussielent, etc. However, for the sake of financial indpendence, your living expenses should not exceed your passive income because you must minimise the amount of time you are dependent on your job.

Because you salary sacrifice into super, there is a good chance a large chunk of your net worth will be in illiquid assets, so your living standards will be low up until you are 60 and then suddenly after 60 you will have a very high standard of living.

Retirement (or semi-retirement) in Southeast Asia

If you salary sacrifice into super, you will have a considerable amount of money in your 60s or 70s, but before you are old, you will likely live a minimalist lifestyle assuming you live off dividends. A way to increase your standard of living is to retire early in Southeast Asia where the cost of living is lower. Before I spoke about how $1000 per month is enough to live a very minimalist lifestyle in Australia, but in many Southeast Asian cities e.g. Chiang Mai, Ubud or Sihanoukville, $1000 per month can afford a more comfortable standard of living. You can retire early and then come back to Australia in your 60s to collect your superannuation and then retire in Australia. Because Southeast Asia is a bit “rougher” than Australia, younger people in their forties or fifties can tolerate it better, so if you end up retiring early in your forties or fifties living off dividends, you can go to Southeast Asia for retirement and then come back to Australia to cash out your super. One of the benefits of living in Australia is its socialist healthcare system (Medicare) that provides free medical care for all. This is particularly useful for older people. That being said, if you reach the age of 60 or 70 with net worth of $2 million, that sort of money can buy good healthcare even in e.g. Thailand. Cities such as Bangkok have international-standard private hospitals that many people from all over the world travel to for medical treatment.

Disclosure: I currently own IHD.

Why Retirement is Similar to Marriage

Within the financial independence community, there is a lot of talk about the date when you retire. Many people talk about having e.g. 4 years of work left before they save up enough money to retire.

However, I have heard of many people who retire who end up disliking retirement. Perhaps they realize that they don’t have enough money to to live the life they want to live. Perhaps they realize they are bored without a job.

The entire idea of having a fixed date at which you retire sounds very final and drastic seems very similar to marriage. When you marry someone, you bind yourself to being with someone for the rest of your life under threat of legal and accounting costs. The same applies to retirement. You bind yourself to not working under threat of having to apply for a job again.

What is the alternative to retirement?

Instead of retiring at a fixed point, a more flexible option is to experiment. It reminds me of a famous saying by Deng Xiaoping: “Cross the river by feeling the stones.” Rather than plunging into a raging river, it is better to cautiously and carefully feel for the stones as you cross. Deng used this principle to build modern China. It is always wise to try something at a small scale to see if it works before scaling it up.

An alternative retirement, in my opinion, is simply semi-retirement. Rather than quit your job, simply take a few months off to see how you fare during retirement. Another option is to reduce your hours and work part-time and to pursue projects that interest you rather than force yourself to do work you hate in order to get a promotion.

All this depends on how easily you feel you can find another job. If you have skills that are in demend and feel you can easily find a job again if you change your mind about retirement, quitting your job may not be a big deal. Nevertheless, when you are older, there is a degree of ageism in the workforce, so it always wise to exercise caution. Cross the river by feeling the stones.