Imagine this: you’ve been investing for a while, and one day you realize that the money you’re making from your investments is more than what you’re earning from your job. It’s a thrilling moment, right? But you’re not going to quit your job just yet, because what if it’s a one-off thing? However, if this trend continues for several years, you might start thinking about making some bold moves. Maybe you’ll finally take that long-overdue sabbatical, or even negotiate a severance package to start a new career.
This is the power of compound annual returns. It’s why you should save aggressively and invest for the long term. It’s also why you should think twice before splurging on big-ticket items like a car you don’t really need. For instance, if you had invested the $40,000 you spent on a car 10 years ago in the S&P 500, it would be worth over $150,000 today. Aggressive saving and investing is key to achieving financial freedom sooner.
Now, let’s talk about the difference between investment returns and investment income. When I started working in finance in 1999, my goal was to generate enough investment income to cover my living expenses. I didn’t want to rely on investment returns because that would mean withdrawing the principal, which I didn’t want to do. Plus, a good chunk of my investments were in growth stocks that didn’t produce dividends.
When I left my job in 2012, I had about $80,000 a year in total investment income from a net worth of about $3 million. I was cautious about relying on investment returns to fund my lifestyle, especially since we had just gone through a recession. I wanted all of my investments to continue compounding during the emerging bull market.
Fast forward to today, my original retirement nest egg has grown, and so has my investment income. But with the market being volatile, it might be time to change strategies.
Let’s consider a scenario where you’ve been retired for a few years, and your investments have appreciated from $3 million to $5 million due to a 10.8% compound annual return. If you continue to withdraw at 1.5%, you’ll be able to live off $75,000 a year in gross income. That’s more than enough to live a comfortable retirement lifestyle. But now that you’re older and feel like you might die with too much money, your desire to spend more has increased.
Here’s a bonus: risk-free Treasury bond yields are now at 5%+. So, if you invested your entire $5 million of investments in Treasury bonds, you’d return $250,000+ a year in state tax-free income. Not bad, right?
Now, let’s say you want to use your "lottery winnings" to fund some new initiatives. First, you want to superfund four 529 plans to the amount of $300,000. Next, you want to rent a luxury suite for an around-the-world cruise, which would cost $200,000. After these expenses, you’re left with $4.5 million, which is still $1.5 million more than you need.
So, you decide to take a break from spending and go back to your safe withdrawal rate. With $4.5 million left, you get to live off $49,500, which is still $4,500 a year more than you were living off five years ago.
Now, let’s talk about work. As I plan to transition back to retirement by 2025, I’ve been trying to justify my decision to no longer work so much. As a father of two young children, not working feels like a sin. However, my investment returns have been greater than my active income returns for the majority of years since I retired in 2012.
In fact, working feels more painful when you’re wealthier. After a certain point, spending any amount of time making active income becomes a waste of time. The only way you would spend time making active income is if you truly loved your work.
So, when can you drop active income due to investment returns? There are two conditions: your investment returns should be greater than your active income for at least three years in a row or four years out of the last five years, and your investments should be equal to at least 10X your annual active income.
How long will it take for your investment returns to surpass your active income? It depends on your saving rate and your rate of return. But with a 20% – 50% saving rate and a 5% – 10% annual return assumption, it will likely take between 11 – 25 years.
Finally, let me share a warning: there is a level of capital where you may lose all motivation to do anything. Once your net worth is over 20X your annual income or 50X your annual expenses, apathy sets in. Once your net worth gets to over 40X your annual income or 100X your annual expenses, that’s when you start completely checking out.
So, if you want to stay motivated, you might ironically have to keep inflating your lifestyle! It’s either that or give more money away. You can always do both.
In conclusion, generating enough investment income to cover your desired living expenses may be harder than generating high enough investment returns to cover your living expenses. But if there is a raging bull market, then living off investment returns may be much easier. The reality is investment income and investment returns are intricately tied together. Once you’ve reached your ideal number for retirement, you might want to change your investment composition towards less risky, more stable, income-producing investments.
