Author Topic: How do you generate necessary returns to sustain financial independence?  (Read 4899 times)

davidm

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This is my first post. I am married with two young children (sub 5) and live in the UK.

I would love to retire early but it seems that I have to continue working simply because I cannot generate a decent income from my investments.

The situations is as follows:
Given that we are both around 40, I prefer not to have to draw down on the principal we have to sustain out lifestyle. Perhaps when we are 70 or so, drawing down the principal might be a solution but at 40 it seems too risky.
We currently spend around 3% per annum of our net wealth.
Given inflation of 3-4% this means we need to generate around 6-7% return on our savings (3% for lifestyle, 3-4% to keep pace with inflation).
Generating 6-7% would be hard enough, but this is a post tax number. To generate 6-7% post tax requires us to return something between 10.5%-12.5% per annum given prevaliing tax rates in the UK.

Generating low double digit returns would seems hard enough pre crisis but with with savings rates and government bonds both producing negative real yields it now seems impossible.

How are other people generating the required returns? Is it that spending 3% is far too high? Or is it just that the combination of higher UK inflation and higher taxes than compared to the US makes the hurdle rate just more difficult?

Any thoughts/insights appreciated!

Thanks

grantmeaname

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Re: How do you generate necessary returns to sustain financial independence?
« Reply #1 on: January 27, 2013, 10:04:00 AM »
Welcome! I'm planning on owning almost nothing but stock index funds, for a set of requirements almost exactly like what you list. There are a few good MMM articles on the subject (in chronological order):
What am I supposed to do with all this money
How to make money in the stock market
Your money can work harder than you can
Book Review: The Intelligent Asset Allocator, which is only kind of a book review.

Another good place to look is the Bogleheads website and wiki (see getting started and philosophy). And you're always welcome to ask questions here... the Investor Alley topic is a good place for questions like yours.

MooreBonds

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Re: How do you generate necessary returns to sustain financial independence?
« Reply #2 on: January 27, 2013, 10:27:57 AM »
Welcome to the forum!

The question of early retirement portfolio safe withdrawal rates (SWR) is one that I and a few others disagree with the majority on this forum, and your specific situation is the perfect example: The oft-cited "4% SWR" that many on this and other sites quote as gospel was the result of research by a few people to find out what amount ANY retiree could withdraw from a diversified portfolio of investments at ANY period in history, and still not run out of money (including retiring in 1929 on the eve of the Great Depression). They studied the stock market returns from 1890 up until today, in 30 year period timeframes, with periods starting each year, to see what they could spend each year and not run out of money:

http://www.fpanet.org/journal/CurrentIssue/TableofContents/ASaferSafeWithdrawalRateUsingVariousDistributions/
http://www.retailinvestor.org/pdf/Bengen1.pdf

The 2 big problems with this 4% SWR:
1 - it's based on a 30 year period. If you start year 31 with just $500 to your name, it's considered a 'success', since most retirees pull the plug at 65, and they limited their initial study to a 30 year time period.

2 - it's based on US retirees. When research is done on other countries, the US actually comes out almost at the top (only Canadians had a higher SWR). Nearly all other developed countries in the study had lower SWR of 3.5% down to as low as 0.5% (Japan). The 4% SWR assumes you spend part of your portfolio in some years (depending on how stocks/bonds do) along with interest/dividend income.

Here's a link to a study for other countries:
http://www.fpanet.org/journal/CurrentIssue/TableofContents/AnInternationalPerspectiveonSafeWithdrawalRates/

Subsequent research has yielded that a retiree looking at a 40-50 year retirement must have a considerably lower SWR for the same 'safe factor' (unless you are ok with slashing expenses and/or looking for work). I don't recall the number, but using US data, I believe the 40 or 50 year SWR was a hair above 3%.

Personally, I'm hoping to retire at about 45. In order to do so, I'm hoping to live off of my dividend income from my investments, at around 2.75% or so overall yield (with some higher-yielding fixed income thrown in to bump up the overall yield). This would permit my income to grow somewhat with inflation over time (as companies raise their dividends, when their profits should hopefully grow with inflation).

I'm unfamiliar with tax rates in the UK. One thing to keep in mind - do a sample income tax return for yourself to see what you would owe net in taxes if you lived solely on dividends/interest/capital gains income. In the US, people are surprised to see that all of those taxes they paid while working (Social Security, Medicare, etc.) help make their net average tax rate noticeably lower, so they don't need as much income from dividends/interest to fund their expenses.

It is challenging to find investments yielding a higher return, but they do exist. The first step is realizing that firing a financial advisor is probably the first step you need to take (if applicable), since their fees are usually not worth it. Next is to simply educate yourself more on what different investment options there are to pick from, and what kind of yields/returns they offer (dividends, interest, etc.)

davidm

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Re: How do you generate necessary returns to sustain financial independence?
« Reply #3 on: January 27, 2013, 02:08:45 PM »
Thanks for the comments.

I'm definately not a believer in 4% SWR. I wish I could but its seems just staggeringly optimistic for the western world which is now running into huge demographic issues caused by the retirement of the baby boomer generation. People worry about the UK having a 1trillion government debt but that is dwarfed by the 5trillion unfunded pension liability. I've written off the idea that I will ever get a penny back from my tax proceeds in a pension. Dependency ratios are now moving rapidly higher and taxes in the UK can only go up to pay for those overgenerous public sector final salary pensions (yes I am bitter that I dont have one!).

I've checked my tax status. I can probably avoid the 45% income tax rate but the 40% rate is hard to bypass given how low the threshold is (oddly it never really rises with inflation!). Dividend taxes would be 32.5% and capital gains would be 28%. However, to assume that capital gains tax would not be eventually harmonized (i.e raised) to income tax levels might be optimistic; it's an easy way for the government to grab additional revenue.

The real issue for me is that the UK has slashed back on tax sheltering through pensions. In the last few years I've only been able to shelter 50k/year and that has now been reduced to 40k. Once upon a time that was 250k/year (but I didn't have any cash to save then). The've also capped pension pots at 1.25mm which seems a lot but given how low CPI linked annuity rates are, 1.25mm doesn't actually provide a big income steam at retirement.

As a result most of our investment returns are fully exposed to tax. The result is that I've have to invoke a (dreaded) financial advisor to construct an offshore vehicle (with all the costs and hassle that creates) to create somewhere where I can roll-up investment proceeds tax free until the point of distribution. Hardly optimal but gross roll-up of income returns and tax deferral to a time of my choosing is is just so key to optimizing the cashflow structure.


Captain and Mrs Slow

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Re: How do you generate necessary returns to sustain financial independence?
« Reply #4 on: January 27, 2013, 02:27:48 PM »
Good article from MMM but Andrew Hallam in his book Millioniare Teacher makes a better case for both bond funds ( there not just for wimps anymore) and international funds. The key is you rebalance once a year, this forces you to buy low and sell high.

He's Canadian and lives in Singapore so  his book is written for the international crowd so It doesn't matter where you live. Most important is the book is easy and very entertaining to read. Certainly more interesting than the intelligent asset allocator. 

For those who want an I depth look at the 4% withdrawal rate I suggust How Much Money Do I Need To Retire by Todd Tresidder, good but more for the hard core PFer.

Nords

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Re: How do you generate necessary returns to sustain financial independence?
« Reply #5 on: January 27, 2013, 02:42:25 PM »
Certainly more interesting than the intelligent asset allocator. 
I enjoyed that one, but even Bernstein tells people to read one of his other books...

shaunr

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Re: How do you generate necessary returns to sustain financial independence?
« Reply #6 on: February 14, 2013, 01:21:46 PM »
Generating 6-7% would be hard enough, but this is a post tax number. To generate 6-7% post tax requires us to return something between 10.5%-12.5% per annum given prevaliing tax rates in the UK.

Hi David.  I know very little about UK income tax other than what I just pulled up on Wikipedia, so please correct me if I'm wrong but...

I think you have a misunderstanding of marginal tax rates.   As an example, someone making 35,000 has moved into the 40% tax bracket, however their effective tax rate will only be around 25%.   You only pay the higher tax amount on the dollars above the threshold - not all of your income.

To take home a 6-7% return, you should only need to net 8-9.3% (actually lower since the data I'm looking at is for employment income, and dividends / cap gains rates are a bit lower than that).  This should be much less intimidating than the 10.5-12.5 you mentioned :)

Onlyif

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Re: How do you generate necessary returns to sustain financial independence?
« Reply #7 on: February 14, 2013, 03:02:44 PM »
Are you sure your looking at the tax rates correctly?  That seems crazy that you need almost double the return to account for taxes.  Canada has high tax rates and it's nowhere near that bad if you use a few methods to lower your taxes like:
- Putting the high tax investments in sheltered accounts,  ie interest is taxed at a higher rate than dividends so bonds go in tax sheltered accounts and stocks go in fully taxable accounts. 
-Won't you be in a low tax bracket as a retired Mustachian? 
-Stock index funds/etf's don't return many capital gains until sold,  which in theory you do in small amounts each year which keeps you in a low bracket.
- Investments in joint accounts so you and your spouse split the income and pay less tax


Running a Monte Carlo simulation might give you some piece of mind.  Would you accept a 90% chance of your money lasting 50 years?  95% etc,  those extra few percentage points can cost you years of freedom :)

Free simulation from Vanguard here:
https://retirementplans.vanguard.com/VGApp/pe/pubeducation/calculators/RetirementNestEggCalc.jsf

Also don't forget that once your retired in your 40's you will probably make money without even trying by following your interests the way MMM does.

 


daverobev

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Re: How do you generate necessary returns to sustain financial independence?
« Reply #8 on: February 14, 2013, 03:05:17 PM »
Hi,

6-7% ROI is completely reasonable. The whole point of the Couch Potato way of investing is that.. if one thing doesn't do well, other stuff will.

I assume you're investing in your ISA first? From my perspective, the UK's tax regime is absolutely awesome. Ok, NI is a bit of a pain but hopefully you'll get something back from that in time (140 quid a week - more than enough to live on, IMHO!).

I assume you are buying HUKX or VUKE, HMCX, H50E etc, etc. They have good MERs; buying on a "regular investment" with my broker (iweb) costs 2 pounds per transavtion, and as these are Irish domiciled there is no stamp duty (at least, I think that's why - but you don't get the dividend tax credit stuff).

*IF* you chug away at your pension (tax free lump sum at 55, I think?), fill your ISA your tax rate.. is not going to be high, assuming you aren't earning hundreds of thousands - in which case, well, you don't really have a problem, right?

Think about an investment property - it should return a few percent, and generally the value of the house should keep pace with inflation.

Couch potato and diversity works just as well in the UK as anywhere else, I think.

You do know the personal allowance is going up to 10k over the next couple of years, per person? Again IMHO - 10k is a lot of cash to spend, if your mortgage is done, and most of your money is in an ISA...