My series on achieving financial freedom continues with an exploration of steps you can take in your 40s. This is a continuation of my articles exploring steps to take during your 20s and steps during your 30s. 

A quick recap of the previous articles. I argued for prioritising retirement savings and getting as much into super as possible through concessionary and non-concessionary contributions. Retirement is a common goal for all investors and the combination of long periods of compounding and the favourable tax treatment in super is hard to beat.

After putting yourself on a good trajectory for retirement it is time to move on to investments outside of super. Everyone has a different definition of financial freedom. The one common denominator is gaining some sort of sense of freedom from worrying about money. And generally, when people say they don’t want to worry about money what they really mean is they don’t want to have to worry about the source of money – a job.

For some people this freedom is conceptual. Just the knowledge that you can tell your boss off and walk away is enough. Some people want the freedom to work part-time. Others want to follow a passion in a lower paying profession. And some want to walk away completely.

Regardless of the definition of financial independence there is a need to convert net worth into liquidity at some point prior to retirement. And this fact will inform the decisions made as investors move from the theoretical notion of independence to actually achieving it.

It is also worth acknowledging that achieving financial independence is really challenging. Most people don’t have the aspiration or means to even consider this goal. Having the ability to save meaningful amounts of money beyond compulsory super contributions requires a high salary.

But there are lessons in this series that are applicable to anyone trying to establish a more secure financial position. The importance of an emergency fund, the tax benefits of saving for retirement as early as possible and the benefit of paying off a mortgage are all lessons that apply to everyone.

Come up with a plan

 

Focusing first on retirement is the prerequisite for the achieving financial independence. Taking care of retirement during the decades when a career is established, and many people choose to start families is challenging. But planning becomes easier in a decade when many people settle into a more predictable life.

It is time to get down to brass tacks. Financial independence means getting to the stage where all - or a portion - of life can be paid for from a source other than full-time employment. There are two ways to achieve this goal. Build up a pool of money or cut expenses significantly. Most likely it is a combination of both.

Building up a pool of assets to pay for your life

 

In my previous article on steps to take in your 30s to achieve financial independence I suggested that sometime during that decade it was time to shift additional savings from super into non-super investments.

Once you’ve hit your 40s it is time to come up with a concrete plan. There are two ways that investments can fund all or a portion of life expenses. A portfolio can generate income which is used to pay day to day expenses or assets can be sold off and withdrawn from the investment account.

Taking the income approach has an advantage. The first is that it generally provides greater longevity of the portfolio. None of the holdings are being sold and they will continue to generate income in perpetuity if care is taken to build and maintain the portfolio.

It should be noted that the overall income generated can fluctuate as interest rates rise and fall and dividends change or are eliminated. I’ve previously covered the process of building an income portfolio and using ETFs to build an income portfolio. We also covered the process in a recent podcast. 

The downside to the income approach to financial independence is that it is hard to do. It takes a larger portfolio to generate the same level of cash flow that can be achieved through asset sales.

That is because the yield of a portfolio will generally be less than the safe withdrawal rate over a short amount of time. The other difference is taxes. Long-term capital gains receive a 50% discount to the marginal tax rates. There is not discount for dividends and interest.

The upside of selling off assets to fund withdrawals is that a smaller portfolio is needed at a given spending level. The problem is that the time frame the portfolio can be safely maintained will be shorter.

There are two primary factors that will influence how long a portfolio can support spending needs. The first is the return of the portfolio. Investors have an influence over the return through asset allocation decisions – the mix between growth and defensive assets – and through selecting individual holdings. But the overall market has a say as well.

The second factor is the withdrawal rate. Take a higher percentage of the portfolio out each year and all things being equal it will last for a shorter amount of time.

We often hear about withdrawal rates during retirement. But in this case the non-super portfolio will act as a spending bridge until retirement. This is why it is so critical that retirement is addressed early. But that also needs the non-retirement portfolio does not need to last as long as a typical retirement.

If retirement accounts can be accessed at 65 and the goal is to achieve financial independence at 55 we only need to plan for 10 years. That means a significantly higher withdrawal rate than the 4% that is typically used as a rule of thumb for retirement.

The following chart outlines safe withdrawal rates over different periods of time given different asset allocations. The time frame doesn’t mean the whole portfolio will be gone. We are aiming for safety and a 90% probability that the money will last. If returns are high an investor may be left with a significant amount of money.

withdrawal rate

The differences between the various portfolio mixes is reflective of the volatility differences between shares and bonds. It may sound counter-intuitive that a withdrawal rate would be higher with a more conservative portfolio. The more conservative portfolio will have lower long-term expected returns but the emphasis here is on safety. We have to account for the downside of shares which is that they can fall significantly over the short-term just as withdrawals start.

Once a decision is made on the income or asset sale approach it is time to create a plan. Figure out how large a portfolio is needed to support the spending needs associated with financial independence. Then go through our goal setting process which is outlined here.

Paying off your home

 

Australian’s love affair with real estate is well known. The combination of the leverage inherent in real estate and historic price appreciation has led to many Australian homeowners generating a significant amount of wealth. Especially if a house was purchased prior to the recent run-up in prices.

But there is an inherent problem with having a large portion of net worth tied up in a house. That value needs to be extracted to achieve financial independence.

In fact, without a way to capitalise on the value of the house it can be a detriment to financial independence. A house is expensive to maintain given mortgage payments and upkeep and maintenance costs. Overextend on a house and there is little leftover money to save and invest.

But a house also serves an essential purpose. We all need a place to live. And paying for a place to live is one of the largest expenses that many individuals face. The CPI weighting that is intended to represent how much the average Australian spends on each category of spending allocates 22.24% to housing.

Saving and investing outside of super is essential for obtaining financial independence. But paying off a mortgage can be a decisive factor. In the current interest rate environment this impact is amplified.

I covered the hurdle rate of paying off a mortgage vs. investing in this article. The rate of return needed to make investing worthwhile is high if the investments are held outside of super. And it is hard to argue against paying off a mortgage completely if that is feasible.

The average NSW homeowner pays $4,517 a month on a mortgage according to Canstar. To cover that payment at a 32.5% marginal tax rate requires pre-tax salary of ~$80k a year. Eliminating that payment is a pathway to financial independence. At a 4% withdrawal rate – through dividends or through asset sales – it would take a portfolio of $2m just to pay the mortgage.

This is not a popular approach. Mortgage debt is called “good debt” as it is used to purchase an asset. Fair enough. It is better than credit card debt. Many people use and continually maintain and draw on the equity in their homes to purchase other assets. But at some point, those assets need to either be converted into cash flow or the cost of servicing the debt needs to be eliminated.

Paying off a mortgage also de-risks the financial aspects of life. Predictability into future expenses is a key component of financial independence. The march upwards of interest rates from .10% to 4.10% represents an additional $1,264 in extra mortgage payments for the average Australian. That increase makes achieving and maintaining financial independence extremely challenging.