Financial independence – a lofty goal that most likely means different things to different people. If you are working and earn an income that covers your costs and you do not need anyone to support you (mummy? daddy? a spouse?) then you are somewhat justified to claim that you are financially independent, as in, not dependent on anyone for financial support. For many years that is what the term meant to me, and if anyone had asked me “Are you financially independent?” I would have answered emphatically that of course I was!
As I got older and wiser, however, I realised that financial independence was more complicated than I had initially thought. When I ran my business, for example, I was earning money and could easily cover my bills. However was I ever really financially independent?
The state of Independence (being Independent) is defined as:
Free from outside control
Not subject to another’s authority
So was I free from outside control? Absolutely not – I was dependent on the banks and clients, and a myriad of other entities which impacted my business.
Was I subject to another’s authority? Well I might have been the boss, but the client was king. You know that saying “The client is always right”. Well, that’s a load of rubbish. The client is often wrong and as a supplier you sometimes have to deal with impossible people and somehow find a way of sorting it out. Great fun, right?
So was I financially independent, or truly independent in any way? No I was not.
I have now sold my company and am now looking towards the future. As I explained in previous posts my goals at this stage include forging a new career in the organisation that acquired my company, while also consolidating my finances to attain that highly desired state: true Financial Independence.
Which leads me to my definition of Financial Independence, which I admit is a totally personal point of view. As far as I am concerned Financial Independence is a state of financial safety and freedom from financial worries. I will consider myself financially independent when I have full peace of mind that if something happens and my husband and I lose our primary source of income (our salaries) for whatever reason, our family will be OK.
In order to work towards my goal the first step consisted of identifying what my family’s annual costs are. Luckily I have logged our annual expenses for many years, so this stage was relatively easy.
Once I got to this point the obvious next step was to take into consideration how our family expenses would change with time. There are expenses that will slowly reduce and disappear (eg childcare) and other expenses that are likely to increase (eg medical and home maintenance costs). So I put together a rather complicated excel sheet projecting how each expense is likely to change over the next 15 years.
Clearly life is going to become less expensive as our children get older and we no longer need to pay for their education and childcare. That said I have factored in a budget for Miscellaneous Kid Expenses that will increase over time, because we want to be in a position to help our children as they get started in life.
At this stage I felt pretty confident that I had a good picture of what our future expenses are likely to be, so I moved on to the next phase.
Planning how to finance this lifestyle should we no longer earn our salaries.
As things stand our salaries cover our expenses, with around 50% left over. So we have no problem paying the bills. The litmus test of FI, however, is whether we would still be able to afford all of the above if my husband and I lost our jobs (or quit).
True Financial Independence to me implies that income streams should be diversified. Depending on one passive source of income introduces an element of risk that leads to financial worries, defeating the purpose of the whole exercise. This means that simply investing the money and withdrawing an annual amount, either as a variable percentage of the total invested or as a fixed amount adjusted by inflation does not meet my definition of FI, because I would then worry about the markets crashing, or some other form of financial Armageddon.
So I have developed a plan that involves the following passive income streams:
- Dividend income
- Safe withdrawals (ideally between 2% and 3%, but never exceeding 4%) from our investment portfolio
- Rental income from an existing commercial property
- Rental income from a second commercial property (still to be developed)
- Income from some freelance consultancy work (less than 8 hours a month)
As you can see from the diagram above I expect to be able to safely withdraw an increasing amount of money as our portfolio grows. I used a 6% annual growth and a 3% annual withdrawal in my projections. The 3% will include dividends that we will withdraw and not re-invest, so I feel confident that this is a very safe and conservative approach that should lead to our nest-egg growing over time.
In addition to the money we will withdraw from our investment portfolio we will also have income from two rental properties. Both of these are commercial properties that will be leased for long stretches, so the income should be regular. The first rental property is already rented out but the income is currently being used to repay an outstanding loan. In 15 years’ time the loan will be paid in full and the investment will become cash-flow positive. The second rental property is still currently a project – I will write a post about our plans sometime soon. This property will also be financed by a loan which will be paid off in 8 years, so we will get income from this investment in around 10 years’ time. This is a long term plan!
So what happens when we compare our costs and passive income streams?
The chart above shows that as things stand, we can currently cover our annual expenses with a combination of the income from our freelance work and by withdrawing 3% from our investment portfolio. This could lead me to conclude that we are financially independent. However if you refer to my definition of FI above it becomes clear that having a diversified income stream and also a margin of safety are very important to me, so as far as I am concerned I will not have met my target before years 4/5.
Which brings me to the next stage of my deliberations 🙂 So far I have taken into consideration our basic annual expenses. As I have explained we are not into conspicuous consumption. In the month since I sold my business I have not splurged on any big ticket items. No new car or designer handbags. What we did spend money on, however, is travel – read about our trip to Sri Lanka a couple of weeks ago.
So travel is our poison. That is where the spare euros will go if we have a surplus. In fact when I think about how we would like to live – our desired lifestyle – what I end up with is a budget along the lines of the pie chart below. This is essentially based on our annual expenses as defined previously, with an addition of a travel budget equal to 30% of our annual expenses. We want to go to some far-flung places!
If I map our desired lifestyle expenses versus our projected passive income it becomes clear that it will take another 5 years of saving and careful investment to finance the life of our dreams solely out of passive income.
My husband and I love our careers and our lives as they are at the moment and have no intention of hanging our hats any time soon. We are still not ready to let go and are enjoying the journey. So we will continue working, travelling, saving and investing our money wisely.
However in the meantime, if things change and one or both of us have to leave work we have full peace of mind that our annual costs are covered – we will not have to cut back on anything that truly matters. We may be travel obsessed, but we are perfectly capable of staying put if circumstances demand it 🙂