Early Retirement: Are We Asking The Wrong Question?
The Nest Egg
Almost every financial discussion of retirement seems predicated on the same basic plan: work for a lifetime while saving up a pot of money that you will then spend through your retirement until it is gone. This is the path the average investor is led down by the financial advice industry which earns commissions from managing their growing investments. Most of us start with modest means: we believe we must work 3 or 4 decades to pay our way but if we steadily set aside a small portion, we will eventually have enough of a nest egg to retire. Of course, that won’t be until our 60s, or perhaps late 50s if we are lucky.
This nest-egg approach to retirement savings poses the question, “How much of a nest egg is enough to be sure I will not outlive my money?” It’s a difficult question to answer, since we don’t know how long we will live. It seems prudent to work longer and save a little bit more to have a buffer just in case. Of course this is rather the opposite of what most of us are dreaming of: early retirement.
Early Retirement Requires Income
If you want to achieve financial independence and the ability to retire younger, this nest egg plan doesn’t work. The timeline becomes too long and the variables too many: the pot must be impossibly large to be confident you will have enough. The average person is simply unable to save up enough capital to retire earlier than the traditional retirement age range. For this reason, I suggest that for early retirement, “how much of a nest egg is enough?” is the wrong question.
Wealthy people approach money differently. To the wealthy, earning money through work and saving a portion is the hard way to build wealth. Instead they get their money working for them. They don’t spend the money they earn; they spend the money their money earns. They work, but not because they need to earn money to cover their basic needs: they work to build better income-creating systems.
This way of thinking is foreign to the average person. Most parents teach their children, “You must choose a good career so you can earn good money.” Once we have that income, society tells us that we deserve the good life now and our employment income qualifies us for credit to buy things we can’t pay for up front. The wealthy don’t think this way. They teach their children about how money works and about using credit wisely to invest in businesses that will create income streams and not for consumer spending. Money earns money while career is about pursuing a life path dictated by passion instead of financial necessity.
Achieving true financial independence and earlier retirement requires doing what the wealthy do: building income-creating systems so you can live on the proceeds of your investments or business, rather than the capital. Derek Foster in his book, Stop Working: Here’s How You Can (Underhill Financial Press, 2005) captures this idea elegantly with his analogy of living on the fruit rather than cutting down the trees. If we can live on the earnings of our investments without drawing down their value, we can retire much younger without the fear of running out of money. The question then becomes not “how big of a nest egg must I save” but “how big of an income stream do I need” to quit my day job and pursue the life path I want? It’s not about the pot—it’s about the income.
The obvious advantage of wealthy people is having the seed money to start off along with the support and direction from their family. For the rest of us to achieve early retirement, we must overcome these two hurdles: build up our own seed money and find our own direction. Start-up capital doesn’t have to be cash. With good credit and some equity in your primary residence, you can arrange an equity line of credit that you can use to build your income stream. In fact for early retirement to be possible for the average person, judicious use of credit is necessary. Leveraging can vastly accelerate the time it takes to build wealth. Risk is part of this process, and managing it wisely is necessary to succeed.
Finding Your Path
Consider that different types of investments or businesses require different levels of involvement on your part. If your goal is to stop working, you need your income creation system to eventually become self-sustaining. One option is to invest directly in quality companies that pay steady dividends until you can live on those dividends. This is the approach Foster took, one which enabled him to quit his job in his early 30s, albeit on a modest income. On the upside, dividend income requires little work to maintain and is taxed at a preferential rate. However, since dividends pay out at a relatively low rate, you will need a large amount of invested capital to create meaningful income.
My path has been to invest in quality rental properties with good cash flow, paying down the mortgages while making improvements over time to boost rental income. All my properties are multi-family with positive cash-flow, fully financed from day one. Income covers expenses with room to spare for maintenance while house values have steadily climbed. But the beautiful part is that once the mortgages are paid off, the net rental income will pay for my living expenses without drawing down the value of the home.
Compared to the stock market, rental property investing requires much more time and effort: repairs must be handled, improvements made and new tenants placed when old ones leave. I enjoy how an apartment vacancy can present an opportunity to renovate and offer a better home at a higher rental rate. It’s one of the ways I can put some sweat equity into my business (since I enjoy doing the renovations myself) and reap the benefits for years to come. The potential rate of return on rental property investments can be higher than for dividend income. Plus rental rates can increase over time providing a built-in hedge against inflation. As mortgages are paid down and profit margins improve, management can be contracted out to a property manager.
My new eBook, Rent Smart: Buy profitable rental properties, create quality apartments and place great tenants (2015) covers all aspects of residential rental property investing for Canadians. If you are wondering if rental property investing is right for you, Rent Smart will take you through the process from analyzing neighbourhoods and properties, to buying and financing, and maintenance and improvements. Rent Smart also covers the best way to approach advertising, tenant screening and applications, lease agreements and dealing with tenant issues. This comprehensive book is my way of sharing over a decade of first-hand experience in rental property investing that has been for me both personally rewarding and highly lucrative.
There are many different types of businesses or investments you can pursue to build your wealth. Each person must go through the process of soul-searching and research to decide on their financial goals and the path they will follow. For some, being their own boss doing something they love may be their definition of success. Others may be working toward early retirement and freedom from work to travel or pursue other dreams. As soon as you can create a stable income stream you can comfortably live on without touching the capital, you can retire regardless of your age. It doesn’t rely on your net worth because you are not drawing on your net worth. In fact, if you are living only on your income stream, your net worth could potentially increase even after retirement. You can retire earlier with confidence that you will never outlive your funds.
Margot Bai’s new eBook is Rent Smart: Buy Profitable Rental Properties, Create Quality Apartments and Place Great Tenants (2015). Also newly revised and updated in eBook format for 2015 is her first title Spend Smarter Save Bigger: Finding BIG Savings in your Home, Mortgage, Vehicles, Insurance and Investments. Download free samples or buy the complete ebooks at www.margotbai.com.