Travel more with a better alternative than saving for holidays
Passive income can be harnessed to reward your future self
Mentioned: Vanguard Australian Shares High Yield (6429)
It has been hard not to hear about the tax cut we recently received – widely known as the Stage 3 tax cut.
NAB surveyed Australians about what they were going to do with the extra cash, varying between $350 and $4,500 extra annually depending on income levels. The data shows that there’s a sizeable segment of Australians that are using the funds to help meet increased costs given the higher cost of living (29%). It also shows that 36% plan on saving the extra funds.
When you dig a little bit deeper the goals of saving money is for the following: .
- Travel: One third of respondents are saving for travel and a rainy day fund, with an average savings goal of $17,000.
- Home: One in four are saving for the lofty goal of owning a home.
- Retirement: One in five have their sights set on a comfortable retirement.
Travel was the most common goal across all respondents. Another study from moomoo surveyed over 1,200 participants and found that Australian millennials are prioritising travel over almost every other goal, with 48% listing leisure as their top financial goal. This is not surprising. Have you ever met anyone who does not believe that they find travel enriching? Especially considering we have come out of a period of exceptional circumstances where we weren’t able to leave the house let alone the state or country– travel is front of mind for many of us.
We feel as though we have a travel debt that we need to catch up on and this is reflected in how Australians plan to spend the extra cash.
People are saving for their holidays from their wages and building up the savings before spending it. However, there are a few thoughts on structuring a travel fund to consider.
1. Travel can be, but is not a finite goal
There are some financial goals that have a certain end point – for example, in the NAB study the $17,000 of savings may cover a finite number of holidays. It is usually just the one.
Travel is often a recurring goal. Most people do not decide that they are going to go on one trip and call it a day.
For recurring goals think through how much you need for your travel goal and how often you need it. For example, I want to have $15,000 a year to travel with my husband. If I want a longer or more costly break – say, to Europe for four weeks, I can use the same $15,000 from two years of savings for a single holiday.
2. Travel costs continue to increase
Travel used to be very, very expensive. As commercial travel became scalable, it became cheaper and more accessible for the everyday person. However, it has reached a point where there are few additional efficiencies to take advantage of. Now, like everything, travel costs increase over time with inflation.
Your goal might be to have recurring yearly travel over the next 20 years. That original $15,000 is not going to have the same purchasing power in 10 years, let alone 20. Therefore, it is important when considering a recurring goal that it is a moving target. You will need to account for inflation.
3. Hybrid approaches
Not many of us will ever have the opportunity to create a large pot of money to throw off enough income to comfortably fund a couple of luxurious trips overseas a year. What if 50% of your holiday was funded? What if 10% was? When going through this exercise, you will be able to determine what is feasible for you and your goals.
Part of this process is realising that there is an opportunity cost to saving for the future. It means you are not spending it on holidays (or other goals) now. This is an opportunity cost that I am trying to balance now.
I spend most of my time surrounded by messaging that stresses the importance of getting started early and the magic of compounding. I write about it myself. It’s easy for financial commentators and advisers to tell you that the money is better sitting in the share market where it compounds rather than spending it.
In theory, this is of course true. Warren Buffett used compounding potential to decide the value of goods and services – famously, the $300,000 haircut. A haircut might cost $30, but he was stressing the opportunity cost of not investing the money and having it grow to $300,000 in the future.
When it comes to travel and leisure, you can save to have more luxurious or longer experiences when you are older. My perspective is that your tastes, preferences and inclinations change over time. This should be consideration as you plan out your approach.
I was recently on holiday. I went to beach clubs in Capri. I climbed mountains at 30-degree inclines in Lake Garda. I watched my husband and friends go cliff diving in Milos (no matter my age, that’s not for me). I swam a fair distance into old pirate caves. These are experiences that I would be able to afford ten times over if I invested the money instead and let it compound – but would I have the ability or proclivity to do it at a later age?
There is no blanket solution to the trade-off between instant gratification and saving. I’ve always been a saver. Spending a large chunk of money is never pleasant until you feel enriched by the experiences. It is cliché to say ‘You Only Live Once’, but taken too far and you risk financial instability.
My approach is splitting my goal into two – one is for short-term saving and holidays. The other is for longer term travel funding. I have chosen to delay reaping the dividends from my travel fund and having less extravagant or frequent holidays in the short-term.
Let’s get back to working out how much you would need to have a passive portfolio to fund travel. Theoretically, this approach looks to use the income while preserving the capital. If invested the capital can continue to grow although it is important to note that most published returns include the reinvestment of income. And the income is an important component of returns. If you are spending the income you will see less growth.
The growing pot of money can still help you achieve other financial goals. This may be important to you as part of your legacy and estate planning. However, you can also draw down on this capital as part of your strategy, because at some point – you are not going to be as mobile or travel inclined.
How to know how much you need for your travel goal
The first step is understanding the income that you are going to generate. This will change, but there are several main asset classes that issue income:
- Property: rent (Gross yield sits between 4-5% since 2010 - SQM research)
- Fixed income and cash: interest (Average over the last 10 years, 3-4% - Moneysmart)
- Shares and managed funds/ETFs: Dividends/distributions (Average 3-5% over the last 10 years, with a franking rebate between 1-2% - ATO)
It is important to note that these are gross returns, and different asset classes attract fees, transaction costs, maintenance costs and taxes. When you receive income, tax needs to be paid on it. Keep this in mind when assessing your return.
You do not need to prescribe to one church and can diversify across these asset classes. The general rule is that the more secure the income stream, the lower the return. Any income investing strategy should consider the sustainability of the income stream.
I’m going to keep this simple and invest in shares and managed funds/ETFs. For this example, I will use the Vanguard High Yield Index Managed Fund. The 5-year distribution is 5.45% (at 23 July 2024).
To simplify this example, I will take a conservative franking rebate of 1%, bringing the income to 6.45%.
As I’ve used a managed fund, there are no brokerage costs to consider like with shares and ETFs, or any maintenance costs such as house repairs with property.
Then – we must consider tax. For someone on a median salary of $100,000, the effective tax rate is about 23%. You can work this out using websites such as paycalculator.com.au.
(Tax paid/gross salary) x 100 = effective tax rate.
This brings the net return to approximately 4.96%.
The maths is simple from there. What is the capital base needed to generate $15,000 with a 4.96% return?
Divide $15,000 by 4.96%. The answer is approximately $302,419.
That is a large capital base. To get to this amount, it requires sacrifice. Let’s say that I focus purely on building my capital base and reinvest dividends.
There are a few pathways to get to this goal. The levers that investors can pull are time (how long you’re invested) and additional contributions. Increasing one of these will reduce the other.
- You could reach this goal in 7 years with $3,000 of contributions a month between two people.
- You could reach this goal in 4.5 years with $5,000 of contributions a month between two people.
Alternatively, you could adjust your goal. Say, as we mentioned at the beginning of this example, that you were happy to receive 50% of your income payments from your fund. You could adjust your goal down to reach it quicker and supplement your short-term travel savings.
You need the income to grow
It would be great if the cost of goods and services were to stay static for the next 20 years. Unfortunately, that is not going to be the case. We need to account for inflation in this exercise.
Again, there are a few ways to approach this. The low maintenance option is understanding that your travel fund is finite, and drawing down on the capital to make up the shortfall. In this same example below, reducing your capital base by $375, $759 and so on. This works if there are no intentions for legacies or other goals attached to the capital base when travel becomes less feasible (such as specialist health care or housing).
The second option is to continue contributing to your capital base.
The last option is to invest in assets where income grows at least as fast as inflation. This could be income from property, where rent can be adjusted for inflation, or investing in shares that grow their dividends. My colleague Mark LaMonica has written on these shares and where to find them.
Investments to fund the life that you want
Ultimately, investments are just vehicles that help us to reach our financial goals. Although this example focuses on travel, all we are doing is creating a source of passive income.
Passive income offers flexibility. It gives its recipient the freedom and independence to make decisions that align with how they want to spend their time. The income that comes from this fund is earmarked for travel, but at the end of the day can also help in cases of job loss, large costs such as house renovations or unexpected medical costs. It offers a more comfortable life and peace of mind for the recipient. This is something that all of us desire.