What does it take to be financially independent? Retirement is probably best defined as a number, not an age. However, some people achieve that number and don't retire, so perhaps we should instead say FINANCIAL INDEPENDENCE is a number, not an age. There are two schools of thought out there about what that number is. I think the first method has the advantage of being theoretically more correct. The second, however, is not without its advantages.
The first school says financial independence is a level of assets. For ease of discussion, we'll call it 25 times what you spend in accordance with the 4% rule guideline. So if you spend $100K a year, you are financially independent when your nest egg is equal to $2.5 Million. You can now spend 4% a year adjusted upward with inflation each year. More or less. Probably.
The second school of thought says that financial independence is a level of income. When the income being produced by your investments is equal to your spending, then you are financially independent. So, if you spend $10,000 a month, when your investments produce $10,000 a month, you are financially independent. More or less. Probably. We'll call this school the “Income Approach to Financial Independence”. Let's go through its pros and cons.
Pros of the Income Approach
# 1 Easy to Know When You’ve Reached Financial Independence
One of the parts I like best about this approach is that it is really straightforward. If you spend $100,000 a year, when your investments produce $100,000 a year, you know you're there. There's no dickering around arguing about safe withdrawal rates. $100,000 goes into the checking account and $100,000 comes out. You can even break it down to the month and week if you want.
# 2 You Tend to Leave More to Your Heirs
Since with this approach you never spend principal, you are likely to leave more money behind to your favorite heirs and charities. At least you know you'll leave something, which, although unlikely with the other approach, is not impossible.
# 3 You Can Reach Financial Independence Faster
Many of those who endorse the income approach to financial independence are big fans of leverage, real estate, and entrepreneurship. Done well, all three of these generally lead to earlier financial independence than a straightforward traditional portfolio asset-based approach combined with a standard J-O-B.
# 4 Behaviorally Easier to Spend Money
However, in my opinion, the biggest advantage of the income approach is behavioral, not theoretical. Most retirees struggle to spend the assets they have spent a lifetime acquiring. Every year I beg my parents to spend more money on anything they think could even possibly provide them more happiness. I was so proud to see them fly first-class recently, probably for the first time in their life. I think many people are like that. After a lifetime of carefully shepherding assets, saving, investing, shopping carefully, and watching expenses, it's difficult to sell assets even when you know it's the right thing to do. It is hard to remember that building wealth isn't the end goal. You save money not to swim in it a la Scrooge McDuck, but to spend more money later. I think pension holders have much less difficulty spending than others, and the income approach is much more like a pension.
Cons of the Income Approach
# 1 Oversaving
One problem with the income approach is that it can lead to oversaving. The truth is that we are not a pension fund or a university endowment. We will all die eventually, and none of our wealth will go with us. It is entirely reasonable to spend principal during retirement. You don't want to spend so much that you run out before you die, but if you don't spend any at all, it just means you oversaved. It's the flip side of leaving more to heirs. It might even mean you worked longer than you otherwise needed to, especially if most of your investments have a relatively low income/return ratio like stock mutual funds. Working longer than you needed to when you didn't want to is a real tragedy.
# 2 Tax-Inefficiency
If you are building an income portfolio, you are by definition generating more income than you need from the time you start until the time you quit your job. From a tax perspective, you don't want to ever have more taxable income than you actually need to spend. It's tax-inefficient. On the eve of retirement, you are generating twice the income you actually need, and paying taxes on all of it. That's a lot of waste (even if your fellow citizens are very grateful for the largesse).
Income-focused investors make a ton of tax mistakes. I've been amazed at the lack of tax knowledge among some of them. Some of the common mistakes they make that result in paying more taxes than needed include:
- Passing on the use of tax-protected accounts like 401(k)s, Roth IRAs, HSAs, and 529s
- Preferentially using investments whose yields are subject to ordinary income tax
- Preferentially using investments with a high income/return ratio
The ideal investment from a tax perspective pays out no income at all until that income is needed, and then pays it out in a tax-advantaged way. Berkshire Hathaway stock is a good example. You could buy this stock when you're 30 and then die 50 years later, never having paid a single dime in tax on an investment that may now be 32 times larger than when you bought it five decades previously. And if you do need the money, you “declare your own dividend”, sell a few shares, pay taxes on it at your Long Term Capital Gains (LTCG) rates and move on. Any investment inside a Roth IRA works the same way. Tax-deferred accounts can provide similar or even larger tax advantages.
The income approach leads people to do dumb things from a tax perspective.
# 3 Funny Investment Choices
If you're not careful, focusing too much on income can result in a portfolio full of lousy investments. The higher the ratio of income/return, the more attractive an investment becomes to an income-focused investor. If you compare an investment that pays out 8% of its 10% return each year as income to an investment that pays out 2% of its 10% return, then the income guy is going to go with the first investment every day of the week and twice on Sunday. However, what happens with some investments is that the investment pays out 8% of its 5% return, i.e. some of the income being paid to you is not income at all, but principal. An investment that returns 5% a year is not superior to one that pays out 10% a year, even if its income is higher. Over decades, that sort of thing can make a huge difference. Here are a few examples:
A. Junk Bonds
These are the classic high-yield bonds. The chart below is a chart of the Net Asset Value of the Vanguard High-yield Corporate Bond Fund from 1985 to the present.
This is obviously a chart that does not show the dividends. The actual return of this fund over the last 43 years is not too bad, over 8% a year. But the payout has obviously been higher than the return. Some of that payout is, in reality, just the return of your principal.
B. Peer to Peer Loans
Another example might be peer-to-peer loans. With this asset class, you're making unsecured loans to people that then are using your money to pay off their credit cards or pay for their weddings or whatever. They may be paying 15-30% in interest. This is the yield. But due to frequent defaults, your return may be only 6-12%, even in a carefully managed, diversified pool of these loans. If you're spending the entire yield while the defaults are slowly eating up your principal, you will eventually run out of money.
C. A Very High Cap Rate Property
The Capitalization Rate is the rate of return on a fully paid-off rental property after all expenses. Imagine a $100,000 property that charges $1,000 per month in rent. Let's say it has $6,000 a year in expenses. That leaves the owner $6,000 in profit. $6,000/$100,000 is a capitalization rate of 6%. Not too bad. In some markets and communities, you can find properties with cap rates of 8%, 10%, or even 12%. These properties obviously provide A LOT of income. Yet in other communities, cap rates might only be 3% or 4%. Why would an investor be willing to buy a property with a cap rate of 3% when they could drive a few hours and find one with a 12% cap rate? The reason why is that investors as a whole judge that 3% property to be much more likely to appreciate over the long run. In fact, cap rate 12 properties are likely depreciating, and fast. That's why they sell so cheaply. If you graphed their price over decades, it might look like that chart of the junk bond fund above, especially if you index it to inflation.
Compare Los Angeles to Detroit over the last few years.
Which cities do you suppose are likely to have the higher cap rates, Los Angeles and San Diego or Detroit and Chicago?
The bottom line is you need to choose your investments based on the merits of the investments themselves and the likely total overall return for the risk you are taking, NOT just the yield on the investment. That's where you get into trouble.
# 4 The Highest Income “Investments” Require More Activity
The biggest issue with the income approach, however, is that the things that provide you the highest income are not necessarily investments at all. While considered “passive income”, they are more like second jobs. Consider a successful physician finance blogger who over the course of 5 or 6 years develops an audience, advertising relationships, and products to the point where the blog income is as high as his physician income. This doctor has now created “financial freedom”! But it's really only freedom from practicing medicine. It isn't freedom from working, because I can assure you, a blog like that requires a lot of ongoing work. Whether you are coaching, teaching courses, or doing medicolegal work, it's really all the same. It's hard to argue that is true financial independence, even if you like the work you are now doing more than what you used to do.
Real estate can be pretty similar. It's really a spectrum. If you are managing 100 doors, you've got a full-time job. So you hire property management, but discover you've still got a part-time job managing the manager. Even if you're only investing in very passive real estate syndications, somebody still has to select and evaluate the syndications as you go along. That's work. So you shouldn't be surprised that an investment you are actively working in has higher returns than an investment that does not require ongoing work.
What about books or courses? Well, somebody still has to put in a lot of work on the frontside to generate that stream of income down the road. It's not just “passive income”.
The only truly passive income out there is interest from your bank account and dividends from index mutual funds that you buy with automatic purchases. Everything else is a combination of an investment and a job. Too many investments like that and all of a sudden financial independence doesn't feel like financial independence.
What do you think? Do you like the income approach to financial independence? Why or why not? Comment below!
I think this is a really fair representation of the pros and cons. In reality I think the best option is for a sort of hybrid approach using both the income and savings strategies. That’s what I am aiming to do. But the pitfalls of any income approach that you point out are really important to be cognizant of, especially the tax efficiency part.
Another great point made is that passive income is not really passive, it’s time leveraged. Still worth it, but not truly passive…
Does the 4% rule take into account ones tax liability?
The 4% Rule is agnostic to how you spend your money.
You may find that your tax liability is minuscule in retirement, but like any other expense, it’s a part of your budget and needs to be considered when determining how much money you plan to spend annually.
Like other line items in the budget, it’s subject to change, so it’s best to estimate on the high side.
Cheers!
-PoF
No. Taxes and advisory fees have to come out of the 4%.
The relative value of these outside income businesses depends on their practice circumstances and the scale of the side hustle. Some docs may earn a higher hourly rate from these activities than that do practicing medicine. For small operations and enterprises that require substantial time, it may be more efficient to see more patients, take more shifts, do more cases than to chase the outside business.
If one wants to have income, as opposed to increase assets, the time to do it may be after retirement. Use the accumulated funds to invest in a business and run it while out from under the time and effort responsibilities of practicing.
By the way, for some of us, working longer than we have to and having money left over at death are not “tragic”. They are goals.
I could retire now. If things go as planned, I will have more money when I die than I do now.
“Living life” is not the same as “spending money”. Much of my enjoyment of life comes from feeling that I am accomplishing something useful. Like a good workout, much of that enjoyment comes from doing something difficult and exhausting . Making money is certainly part of the reason I work, but it is hardly the only one.
I love this.
Consider me a fan, Afan.
Cheers!
-PoF
Great point on the oversaving, especially. I see most doctors always finding a way to not retire, worry about saving, etc
Most of these already spoil their kids; it’d be better for the kids overall to NOT actually inherit very much from the parent, it’s bizarre they don’t understand this most of the time.
Shock and Awe! Great article. I have found the last part about passive income to be 100% true. Nothing passive about it and often there is no resulting income on top of it.
“it’d be better for the kids overall to NOT actually inherit very much from the parent”
I could not disagree more. Why would you think that?
Because the kids are spoiled already – give them small necessities and then figure it out and create character for them, not let them be the same pieces of dookie. Unless you think that they will have nothing, because pending dystopia and war is coming (real possibility) … the problem is that you don’t own crypto and other assets likely, you own the boomer equity market and derivatives which will get crushed anyway …
“not let them be the same pieces of dookie”
What does this mean? Is being pieces of dokie something to be sought after or avoided? Whatever it means, how does it make someone better off with less money?
How would my asset allocation or impending economic collapse make them better off with less money?
Dookie as I spell it is poop. A spoiled brat Rich kid is not a child many parents would be proud of. Having to do some work/ earn some money may help to make a child a better person, and should help them better understand and treat properly those not so well financially situated as they are. Also, it’ll keep them from being clueless and broke after running through every cent of the money you have left them as an inheritance or otherwise be in a bad way if their /your financial situation changes.
The data I have seen indicate that children raised in well to do households are MORE likely that the population as a whole to get college degrees and MORE likely to be in the workforce.
I consider these to be good things. If you know of data showing that those who inherit large amounts are worse off as a consequence, I would love a citation. I have looked and cannot find it.
I CAN find people who repeat this idea that these rich kids do not live productive lives, but no evidence that this claim is true.
If you know of data, please cite it.
Thanks
Afan- I believe your data. I think that is because most rich people are careful to raise good kids or don’t leave the kids enough to be jobless rich jerks (and usually pay well to treat them if they become drug/ alcohol addicts). There won’t be any data proving that some are spoiled brats because it IS anecdotal. With my social class and power the spoiled brat unemployed poor kids are usually respectful to me, and there aren’t too many spoiled brat rich kids in the world that I encounter.
Not everything requires a randomized controlled trial published in a peer reviewed journal. Look up The Rich Kids of Instagram.
Certainly many children of rich people go on to lead productive lives. but those who do not inherit a fortune must be productive in society by necessity, or risk falling through the cracks. The same cannot be said of those with a vast safety blanket.
I assume you’ve seen the economic outpatient care chapter in The Millionaire Next Door, right?
Why not just compare with immediate annuities? Seems like a risk free way to measure financial independence.
The problem with SPIAs is you can’t really get inflation indexed ones any more.
I am likely in the 1% among physicians. I have done it all as far as investing. I have the traditional tax deferred accounts and taxable accounts, with substantial balances. On the “passive” side of things, I have a significant rental real estate portfolio that generates a generous physician like salary each year. I also started a successful side business that after lots of optimization generates an even larger income flow each year. I still see patients on a part time basis.
The active/passive debate can go on forever.
Caring for patients is likely the most active thing I do. I need to show up, be 100% focused and present. The compensation is reasonably high.
Running the business is somewhere in the middle as far as the amount of care and feeding required. I can be skiing in the Alps, and the income still flows. But I will answer the phone if a problem comes up. And I will be optimizing and making executive decisions when not on vacation.
Running a real estate portfolio also requires some work, but the ratio of dollars generated to hours of work required is pretty high. And the tax advantages of real estate investing, in particular for a high income family, are second to none. The real estate investments will save us an outsize amount of income taxes again this year.
The most passive activity is managing the investment portfolio. But there is still some work required. What is my asset allocation? What will the new tax deferred dollars be allocated to, versus the taxable account. What to do with the cash in the portfolio? CDs? Bonds? Munis?
So active vs passive all exists on a scale. It isn’t one or the other, not black and white. I’m having fun with everything I do. I’m leading a productive, busy life. But every day I spend time exercising outdoors with my friends. I have control over the life I have created. I still love caring for patients. And I have tremendous means that allows me to give back so much.
Good for you!
My investments are on autopilot. No need to decide where new cash flows go. Completely passive. Takes no time to “manage”.
If you get a large enough scale, then the time spent managing a business or real estate portfolio can be paid at rates far above those for practicing medicine. But you have to put a lot of money into it. If one builds up to this over time, then the early years, with small investments, may not be nearly so lucrative. For those who are not as good at it, or are unlucky while they are building to proper diversification, there can be losses. These can be large enough to knock some people out of the game.
But for those who are successful, it can be great.
I think the standards usually require multiple unbiased homogeneous randomized controlled trials. Preferably a meta-analysis of such data.
Many things that physicians have thought were good ideas turned out to be wrong when tested. Hence the interest in data, rather than rumor and anecdote.
If my kids had physical or mental health problems, absolutely I would want to provide that warm safety blanket. If the alternative is they fall through the cracks, there is no decision. “Let me help”. Any way I can. I like to think they know this.
CEFs, BDCs, MLPs, and REITs offer diversified and high yield investments though extra expertise (on top of general retail investing) is needed to navigate this universe. Can be great for an income investor and solve the problem of oversaving but must do research and tread very carefully.