17 Nov 2011, 10:52pm
personal finance
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  • Early Retirement is all about Spending Less, Not Earning More

    That’s an odd assertion to make, and illogical to boot, no? If you need to save £10000 a year, and you’re breaking even at the moment, then you could either spent £10,000 less, or carry on spending at the same rate, and earn £10000 more?

    Not so fast. For a start if you earn £10000 more you’ll get to lose £3000 to £4000 to the taxman, so you do in fact have to earn even more. However, there are added ‘soft’ issues. You may have to spend more time at the office or commute further, so your domestic ocsts may rise as you favour convenience over DIY. More subtly, there may be lifestyle inflation pressures.

    For instance, when I go to Canary Wharf I stick out as a slob – I’m the guy in the T shirt and no-label trousers where all around me are designer shirts and well-cut suits. I’ve just looked at what engineering jobs pay there it appears that I earn similar to some of these folks or even a little more, however I don’t need to spend the money on the designer gear 🙂 That’s average engineering jobs – obviously if you’re network admin for a big bank I’m going to be way down in the salary stakes!

    Mr Money Mustache’s courageous outline of the history of his increasing net worth (‘Stash) reminded me of this. When I first looked at it I thought blimey, I haven’t got anywhere near that figure (USD800,000 ≈ £500,000) so either I am outrageously necky even thinking about early retirement or life in the UK is a lot cheaper. Monevator has a pretty similar value for his baseline reference, though unlike MMM his example income replacement portfolio is pure financial assets. However, digging deeper MMM considers his house part of his net worth, and this is a total 360 degree net worth calculation. I’ve never calculated that because of my income focus, and I have a greater diversity of ‘Stash than MMM, accumulated over three times the amount of time, so I’ve never seen a large amount of it in one place. He did me a favour in getting me to tot this diverse mess up. It’s probably at least in the same ballpark, despite the fact that I personally have never seen a single financial transaction or single asset purchase for more than £60,000 in my life. Ever.

    It’s the Spending, not the Earning

    More interesting, however, is how he got there. I built my net worth largely on my own (I was single for longer than most people) so he had the edge with having two people bringing in money to the household, and MMM earned significantly more than I have ever done, so he got there in 10 years whereas I have been working for nearly 30.

    However, it wasn’t that MMM’s household income was higher than mine. It was that they saved a far higher proportion of their income than I did prior to 2009, and invested it. The so called magic of compound interest hasn’t made a large difference to his wealth, this is pure saving. Apart from the value of my pension, which presumably the Trustees invest and use compounding, I don’t think much of mine is due to compounding either, indeed unlike many I don’t rate compounding as a way to make things easier over a working life, Yes, pension contributions you make in your twenties do appreciate numerically, however they better had do, because inflation means the value of £1 then will be a lot more than the value of £1 when you retire. The differential once inflation is taken out is not huge.

    Compound interest ain’t as magical as they say

    I experimented with the Motley Fool’s compound interest calculator. Say I invest £1 a month for my working life of 30 years. Without inflation I would have 30*12=£360 at the end of it.

    Now if I was in an inflationary environment and scaled my annual savings and got interest to match inflation in real terms I’d still have the equivalent of £360. So if I’d started in 1980 and opened my pot in 2010 I would have £1200 in there, but it would have been worth the same as the £360 in 1980.

    Let’s say I’m a savvy investor and get a return of 3% above inflation, I’d be sitting on a pot worth £580 in 1980 pounds. It’s a 61% increase, so worthwhile, but not a total game changer.

    money is drawn to money so if you have money it’s easier to save

    I started my savings from a standing start in 2009, after three years I have savings of twice my gross salary. The heavy lifting here is done the same way as MMM – spending less than I earn, aided by some investment appreciation, some dividend income and a lot of stopping the Government thieving half of it in tax. It really is remarkable how much you can reduce taxation if you don’t need to spend most of your income…

    Unlike MMM, my investment income is pretty poor at the moment, as my ISA is small, and tax-free pension savings are in accumulation mode. Young early retirees need to make their investments pay a decent income quickly, there is the same pattern in MMM and ERE. Mine are operating in the traditional form  of being in accumulation mode right up until they are drawn.

    I have the challenge of trying to bring the post-tax investment income up to service my basic living costs between retiring and drawing my pension, a gap of about three years. Because it’s a near-term requirement unsuited to the ravages of the stock market, I have three years running costs as cash, which is galling because this is about half of my post-tax savings. Cash earns no real income, whereas at least my ISA is achieving its nominal 5% dividend  return. I could double that dividend return by committing the cash to it, but the maths doesn’t work out. A 5% dividend return means you need a stake of 20 times the desired income, and I haven’t got that yet.

    One way to improve my situation would be to reduce my outgoings. The poster child for how to do this in the UK would have to be Macs, who has managed to get his running costs down to £5k p.a. which is a damn sight less than mine. Interestingly enough, much of the difference would be reduced if I didn’t run a car. On the downside neither estimation accounts for the ~1% of house value you should allocate for maintenace and repairs. As owner occupiers we are probably way less hard on the fixtures and fittings, and yet over the last 5 years I have spent over 1% of the house value on repairs and improvements.

    My career profile was much more conventional in that my earnings peak was much, much later in my working career, about 20 years in. However, the common takeaway with MMM and ERE is that you only build up enough capital to get a decent income if you spend much less than you earn – and that much less needs to be about 50% if you want to do something very different to the normal pattern of working.

    For me the savings pattern isn’t anywhere  near as different from the norm as those guys. It’s much closer to Salis Grano, who sums it up in this post titled Where Did It All Go Right. I am insanely jealous of course, as I haven’t got there yet. Unlike MMM who retired after 10 years, thus shaving 20-30 years off his working life, my aim is taking a more modest 10-12 years off my working life, I have already been working three times as long as he has.

    It is one of those ironies of life that saving money is easier once you have money, when of course the people that really need to save money are those that are in debt. It’s how capitalism keeps most of us debt slaves, particularly those who acquire debt young and warm to the lifestyle.

     

     
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