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Friday, 31 July 2020

What really makes FI/RE work?

FIRE (Financial Independence - Retire Early) is a 'popular movement' of people (often Millennials) who are sick of the 'rat race' and consumerism, and wish to achieve financial independence (not relying on a pay check, but instead having a sufficient income stream from investments to either work as they choose, or even do a traditional 'retirement' (stop working) at a much younger age than usual (eg. age 65)). The key to FIRE is often seen as cutting out spending on mere 'wants' and instead using the resultant surplus income to invest.

To give an example of how effective cutting expenses and increasing savings rate can be at reducing how long one has to work until able to achieve financial independence and 'retirement', I did a simple excel model of how long it would take for invested savings to build up to a level sufficient to provide enough passive income to replace the income previously spent while working.

To keep it simple I made the following assumptions:

After tax income (available to spend/save): $100,000 pa for all years

Investment ROI is constant and is 7% pa after tax

Inflation is 2% pa, so the real ROI is 5% pa

In reality, returns will vary from year to year, and even if the average return works out to be 7%, actual results will depend on the size of variations and order (ie. return volatility and sequencing). And while DS1 is starting out in his first job straight out of uni at age 20 with a salary of around $100K (similar to my current salary, and also to the inflation adjusted amount I got in my first job after graduation), many people start out at a relatively low salary level and see their wage increase until their 50s. The actual after tax income level however doesn't affect how the model performs, as the required retirement income is calculated as a percentage of wage - so as long as your earn sufficient to be able to save part of your wage, the income level won't change how long it will take to achieve FIRE.

So, what does the model predict?

If you start at age 21 with zero savings/debt and save 10% of your after tax income, you would achieve the $1.88m investment balance to enable you to retire with a passive income of 90% of your after tax working income at age 68. This would mean you would have the exact same amount of disposable income in retirement as you had (after deducting the 10% being saved) while working.

If you instead saved 20% of your after tax income, you would only require $1.7m to retire, and would achieve that by age 54. The reason you require a lower final investment balance is because you have been living on 80% of after tax income, rather than 90%. This is one of the 'secrets' of FIRE - by adjusting to living on a smaller percentage of your income while working, you can reach that level of investment income much sooner. (If you had instead saved 20% of income, but wanted to still retire on 90% of income, the investment balance required to fund retirement would have remained at $1.88m, but you would have achieved it by age 58 by saving 20%, rather than age 68 by saving 10%.

If you cut spending to boost the saving rate to 30%, the investment balance required to fund retirement reduces to $1.53m, and you'd get there by age 46.

And by saving 40% of after tax income you could retire by age 40 with an investment balance of $1.3m.

By saving 50% you could retire by age 36 (with $1.18m), and by saving 60% you could retire by age 32 (with under $1m).

By now it should be obvious that using FIRE to achieve early retirement is partly a trade-off between retirement age and the level of spending possible both while working and during retirement. Some people who have tried FIRE have found it too hard to cut current expenditure significantly. While how much one can take from current spending and divert towards saving for 'financial independence' will depend on personality (FIRE isn't for everyone), I suspect that some people who find it hard to reduce spending while they are working are in for a very unsatisfactory retirement when they suddenly find their income slashed involuntarily.

The sequencing risk is also not to be underestimated - I always saved around 30% of my after tax income, and was on track to be able to afford 'early retirement' by age 50, but that was before the GFC. So its probably worth building in a couple of extra years as a buffer when planning for FIRE.

Another aspect that I've come to realize is that once you have achieved your 'FI' target you may not want to 'RE'. I actually passed the minimum amount of superannuation savings required to replace my rate of expenditure (current wage income - taxes and savings), and am now working towards hitting the $1.6m transfer balance cap), and hope to transition from working for a salary to working for myself in  my own financial planning business. Achieving financial independence means that you are actually choosing to work (even if it is still in the same old job), rather than having to work.

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Saturday, 18 July 2020

Expenses for past two years

I did my annual budget review, getting most of my expense data from my monthly credit card statements for the past two years, plus some adjustments for expenses paid via EFT from my bank account, and some uni fees I paid using my portfolio loan (ie. I effectively accumulated some 'student loan' liability doing my masters degree). Some of the figures may be a bit rubbery (for example I estimated my tax based on gross salary - tax home pay- SGL/SS deductions. In reality I will probably pay less tax than that, as I have deductions for margin loan interest that is usually a bit more than the dividend income I receive, so I get a small tax refund that I haven't adjusted for).

One striking thing was how similar the expenditure break-down was for the past two years. I don't deliberately spend according to a budget, as my savings are on auto-pilot, and everything else tends to stay fairly constant. I've projected my notional budget for this financial year - which is pretty similar to the past two years. The transportation costs might be slightly lower as I'm currently working from home, and I got rid of the S-type Jaguar that cost me quite a bit in servicing, rego etc. last calendar year. I haven't allocated that savings into any other budget category, so (hopefully) that should mean I accumulate some surplus cash in my savings account over time, and might be able to pay my uni fees from savings rather than increasing my portfolio loan balance.

I'd like to reduce our expenditure on groceries, as it seems quite high compared to some other budgets I've seen on PF blogs, but with two teenage boys that might be hard to achieve, so I haven't budgeted for any savings there. I'd also like to get some clients for my financial planning business (GFP) this FY, so hopefully there might be some revenue to offset the fixed costs of running my business.


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Friday, 17 July 2020

Covid-19 will be one of the leading causes of death in the USA this year

Despite what the US leader (!?) thinks, Covid-19 is not comparable to the seasonal flu. A quick reality check of what he said in March:

"So last year 37,000 Americans died from the common Flu. It averages between 27,000 and 70,000 per year. Nothing is shut down, life & the economy go on. At this moment there are 546 confirmed cases of CoronaVirus, with 22 deaths. Think about that!"

versus reality (as of now): approximately 138,000 deaths (and another 1,500 or so each day).


But how bad is Covid-19 compared to the 'normal' leading causes of death in the USA?


Number of deaths for leading causes of death in the US: [https://www.cdc.gov/nchs/fastats/deaths.htm]

Heart disease: 647,457

Cancer: 599,108

Accidents (unintentional injuries): 169,936

Chronic lower respiratory diseases: 160,201

Stroke (cerebrovascular diseases): 146,383

Alzheimer’s disease: 121,404

Diabetes: 83,564

Influenza and Pneumonia: 55,672

Nephritis, nephrotic syndrome and nephrosis: 50,633

Intentional self-harm (suicide): 47,173


So, Covid-19 is already destined to be at least the 6th leading cause of death in the USA for 2020, and could end up being the 3rd highest cause of death in the USA this year (trailing only heart disease and cancer).


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Thursday, 16 July 2020

Tracking my Net Worth Performance against an iconic benchmark

Once you have an investment strategy in place, it is a good idea to measure performance - both in absolute terms and relative to a benchmark. Absolute performance measurements will let you know if you are 'on track' to meet your financial goals, and performance relative to an appropriate benchmark will let you know if you are implementing your chosen strategy effectively (eg. if your plan is to achieve a return of 1% more than the ASX200 index by investing in what you deem to be the 20 'best' shares in that index, you need to compare the performance of your portfolio to that benchmark - the ASX200 index).

I tend to not worry about benchmarking individual components of my investment portfolio, as my superannuation is invested in a mix of index funds, each of which already has appropriate benchmarks in place, and reporting of fund performance against those benchmarks. And my home valuation 'is what it is', as I'm not going to sell up and move to another suburb on the basis of how prices in our suburb move relative to the overall Sydney house price index.

Instead I benchmark my overall net worth against what I've decided is an appropriate 'stretch' benchmark - the minimum NW cut-off required to make it onto the Australian "Rich 200" list. That list was was originally prepared and reported annually by BRW magazine, and is now published by the Australian Financial Review. It takes a few months to produce, and normally comes out around May-June, based on valuations calculated in late March. This year the 'rich list' has been delayed until '4th Quarter' due to the market volatility that was occurring in March.


The reason that I've chosen to benchmark against the cut-off for the 'rich list' is that I assume that these richest Australians have reasonable expertise at building wealth. By taking the cut-off (net worth of the 200th richest Australian, whoever that happens to be) I eliminate much of the random variation that occurs at the top of the list (which often depends on how a particular investment/company is performing). And because Australia's population is increasing over time, the 'rich list' is getting more exclusive (a smaller percentile of the population) over time, so the cut-off will increase relative to the 99th percentile for example.

As the cut-off net worth for the rich list is still vastly higher than my net worth will ever be (I'll never be on the 'rich list'!), I've chosen to benchmark my net worth against 1% of the rich list annual cut-off. Plotting my monthly net worth (excluding the lake house I 'inherited' a few years ago) against this benchmark shows that I've generally been tracking quite closely to that benchmark, with the exception that my net worth did relatively poorly during the GFC due to my gearing having to be unwound at the market bottom to avoid margin calls - and then not having the confidence to gear up again to my previous level when the stock markets improved during the following decade.

When the annual rich list is published later this year it will be interesting to see when I've made up any ground against the benchmark - hopefully the market timing I attempted with the asset reallocation during the first half of 2020 will have boosted my relative performance.

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Sunday, 12 July 2020

Did DS2s tax returns for the past six years

I bought some shares (Cochlear, CSL and Computershare) for DS2 about ten years ago, as I'd made a similar gift to DS1 around that age. DS2 had his tax file number issued, and the shares were purchased in his name (but with DW and myself as trustees on the trading account, as I couldn't get a share trading account setup in only his name as he is under 18) and the dividends were paid directly into his St George student savings account. The idea was that having actual investments of their own would make the kids' lessons about investing, compound interest, budgeting and saving, and tax a lot more 'real'.

I'd previously done DS2s tax returns for the years up until 2012 and for 2014 (fortunately he didn't get enough annual income to be subject to the 66% child tax rate that applies to minors if they get more than $416 of 'unearned' income, so it was worth doing his annual tax returns so that he got the franking credits on his dividend payments refunded). But I hadn't yet lodged DS2s tax returns since 2014 when the old eTax software was replaced with having to lodge tax returns electronically online via a link of a myGov account to the ATO, which was rather complicated to do for another person (so I didn't get around to it). As DS2 had made undeducted contributions into his superannuation account in each of the past two financial years, I decided was high time that I made the effort to get his myGov account setup (easy) and linked to his ATO TFN (not so easy - for some reason it wouldn't validate using the bank account details, even though once it was setup it turned out that the interest for those account was autopopulated in his tax return!). I had to call the ATO and have DS2 on speaker phone with me (luckily I'm working from home, and DS2 is on school holidays) so we could both identify ourselves and get a linking code issued by the ATO to connect DS2's myGov account to his ATO TFN.

Once that was all done I started working through DS2's electronic tax returns from 2014 onwards. I got DS2 to 'help' do his tax returns, although I must admit that even I find doing tax returns less than exciting (and DS2 certainly was keen to get back to playing Fortnite!) For the first few annual returns DS2 will be due a small tax refund (due to the franking credits), but in each of the past two years his total income was over the $416 child tax rate threshold, so he has a tax liability (that was mostly offset by the franking credits) for those years. Over the entire six years of past tax returns that have now been lodged he'll end up owing about $33 of income tax. It was still worth lodging his tax returns, as he had made $1000 contributions into his superannuation in each of the past two financial years (from money he had earned doing some busking (hobby income, hence not taxable), and various amounts he'd received for birthday and xmas gifts etc.). Once his tax returns have been processed he should get a $500 government co-contribution into his superannuation account for each $1000 annual contribution.

With the covid-19 recession impacting dividend payments, and DS2 having spent some of his bank savings on a gaming desktop computer, its likely that he'll have low enough income from now until he turns 18 to avoid any child tax liability for future income years. I'll encourage him to continue making a $1,000 contribution into his super each year, so that he gets the immediate 50% benefit of the government contribution into his super each year, and the investment will enjoy about 50 years of compounding in a low tax environment (if the current superannuation system doesn't get changed completely over that time) until he retires.

DS2s taxes:

FY    taxable income    franking credits    net tax refund (liability)

2014    424                    34                        34

2016    503                    66                        7

2017    492                    62                        10

2018    541                    60                        (22)

2019    656                    96                        (62)

overall                                                        (33) tax liability

The way child tax works is a bit weird - if they have less than the threshold amount ($416) of 'unearned' income, there is no tax liability, but as soon as they exceed $416 the entire amount is subject to the 66% tax rate. So, if child A had $415 unearned income their tax liability is $0, but if child B had $420 of unearned income their tax liability is $135.20 + 66% of the amount over $416. So it is definitely worth trying to keep his unearned income below $416 - perhaps by not having his savings in an interest earning bank account.

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Sunday, 5 July 2020

Victoria outbreak shows how fragile our control of the Covid-19 pandemic really is

After suffering from outbreaks in nursing homes and returning cruise ships in March-May, Australia seemed to almost have the pandemic 'under control' in May, with States easing the 'lockdown' and allowing many business and social activities to resume, subject to social distancing.

However, there seems to be a combination of lockdown fatigue, conspiracy theory weirdness, wishful thinking, and "she'll be right" attitude making any move to ease restrictions a recipe for another outbreak - especially in Victoria.

Hopefully the current lockdown of some specific suburbs with 'hot spots' of community infection (and six public housing unit blocks, holding 3,000 residents, were around 1% of residents have already been confirmed to be infected) might bring this outbreak under control. Unfortunately it will be a couple of weeks before we'll known if community spread has been suppressed again, and by then the numbers of patients in ICU beds, and the number of fatalities will have risen in line with the current surge in cases.

A plot of reported cases per capita for Australia, the UK, USA, Canada and Germany shows just how well Australia had been doing, and just how badly the current Victorian outbreak has been. Rather than getting a "v-shaped' economic recovery post-lockdown, we have instead had a "v-shaped" rebound in Covid-19 contagion.


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Wednesday, 1 July 2020

Net Worth: JUN 2020

My NW rose about 0.5% during June, reaching a new 'all time high', which is quite pleasing during the middle of a pandemic (although anyone highly invested in tech stocks or a tech index fund during the past 6 months will have made about 35% gain!). Our reallocation of SMSF investments from bond index fund into growth index fund helped boost the performance of my estimated SMSF account balance during June. And my stock portfolio* also showed a small gain for the month. Our estimated house valuation hasn't changed even though new average monthly sales price data was available - apparently the average sale price for houses in our postcode has been constant for the past four months. My share of our home mortgage continued to slowly reduce, as we move past the 2/3 mark of our 25-year mortgage.

The 'other real estate' value remains constant (i.e. left at the cost price) for the off-the-plan $1m investment unit I bought last year and the lake house I 'inherited' a few years ago. And the 'other mortgage' value is being left as the notional cost price of the investment unit (I borrowed the money for the 10% deposit and stamp duty using part of my portfolio loan line of credit, and the remaining $900K is the amount I'll need to borrow to settle when the unit is completed in 2023). For fun I've been tracking one-bedroom unit sales data for the postcode area of my investment unit, and the calculated approximate monthly valuation has been in a modest up trend since I paid the deposit last year. But I won't start tracking the estimated value of the investment unit for my NW calculation until after it is completed and I get a proper valuation done.

But if the current trend in unit prices is accurate and continues until construction is completed in 2023, the unit *may* be worth around $1.5m by that time. Which should make it easy to get a $900K mortgage, and would also mean that my $140K investment (deposit and stamp duty) will have grown to around $600K equity in the property. After deducting the loan for the deposit and stamp duty, and the capitalised interest on the loan, that would result in a net profit of around $412K (subject to CGT). Can't really calculate a ROI for that as the investment was 100% funded using borrowed funds. Of course there is no guarantee that the unit will be worth more than I paid for it, so I could end up losing money.

* the 'Stocks' amount is net value of my geared stock/fund investments outside of super, minus the various margin loan balances and also the balance of my 'portfolio loan' that wasn't used for the unit deposit and stamp duty payment. As the 'portfolio loan' balance is increasing each month by both the capitalised interest, and the transfer of $1,500/mo to fund my financial planning business fixed costs, the 'Stocks' figure isn't really an accurate guide to how my stock/fund investments are performing.

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