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Most of us get into investing because we want freedom, whether from office bores, traffic jams or the drudgery of a mortgage. We want to be free from having to work for a living.
Why then are most money-motivated books called things like The Millionaire Next Door
What we’re really looking for is a replacement for our salary. The number on your pay check is the number you need to beat to retire early. If your monthly wage turned up in your bank account no matter what you did, wouldn’t you feel pretty financially free? You could quit work the next day if you wanted, although there’s no reason to take to the golf course – you could get a fun job, work for charity, or do all sorts of other exciting things instead.
Why you should consider targeting income instead of capital
Generating a sufficient income to replace your salary is still going to require some serious capital to produce all that cash. There are no true short cuts in investing, but I believe there are some subtle benefits in targeting income when making your investment plans:
- Replacing a salary is a more tangible goal for many people. Having £1million sounds like winning the lottery. Getting £25,000 a year sounds more humble, and so more feasible. We only do what we truly believe we can do.
- Better investment decisions. If you’re shooting for the stars, you’re liable to trip in the gutter by taking too many risks. In contrast, if you’re looking to build up a portfolio of long-term income producing assets, you’ll likely take a more measured view.
- Encourages asset allocation. There are plenty of income producing assets (I list a few below). By buying different ones as and when they appear cheap (and offer more income for your buck), you’ll build up a nicely diversified portfolio. Aiming for a capital sum could instead encourage you to focus on whatever is currently hottest, and thus likeliest to come crash down.
- Reduce portfolio churn, taxes and dealing fees. This is a great hidden benefit. If you buy shares in Lloyds Bank, say, which is currently offering around an 8% dividend yield, you should never need to sell it provided the income keeps coming in (and ideally rises with inflation). That means no extra fees for your brokers, and no capital gains tax (or in the UK stamp duty) for the tax man – and so more money for you.
What assets produce income?
Plenty of different assets will reward you with regular cash payments in return for you holding them, ranging from the very safe (cash), through bonds and property, right up to the very risky (such as out-of-favor small-cap value shares that may or may not be about to cut their dividend or, worse, go bust).
In contrast, gold, mining shares and tech stocks typically don’t produce an income. Instead you hope for a capital gain.
In rough order of riskiness (and a correspondingly higher long-term income as a reward), you’d want to consider the following assets for your income portfolio:
- Cash
- Government bonds
- Corporate bonds
- Regular savings into an equity-income unit trust or fund
- Investing in a stock market index-tracking fund
- Investing in a commercial property fund
- Buying residential property to let out (but remember you’ll need to pay for its upkeep, and property may well be in a bubble right now)
- Creating a high-yield portfolio of good dividend paying shares (not actually that risky over the medium term, provided you can ignore the fluctuations in capital)
- Overseas property
- Investing directly in small businesses for a share of the profits
These are just the pure investments – there are other options. For instance, you might consider creating a second income stream, especially if it’s based on a hobby you’d enjoy doing for fun once you’ve retired. (For instance, writing magazine articles or selling dress patterns on eBay).
How much income do you need?
You tell me? Seriously – another benefit of aiming to replace your salary through a passive income stream is you’ll know exactly the figure required, rather than going after the rather nebulous idea of a million pounds, or whatever your currency of choice is.
Here’s a quick example, for fun. Say you’re currently earning £25,000. You might replace that salary with the following income-producing assets:
- £25,000 in cash, yielding £1,250 per annum
- £35,000 in government bonds, yielding £1,250 per annum
- £100,000 in a corporate bond ETF, yielding £5,500 per annum
- £50,000 as a deposit in two well chosen buy-to-let properties together yielding £3,000 per annum after expenses and mortgage interest
- £200,000 in a high-yield portfolio, yielding £10,000 per annum
- An online eBay hobby business you build up over two to three years, which generates £4,000 per annum after costs
Adding all that up, you’d need £410,000 to replace your current salary. Still a huge sum, but not insurmountable. Remember, most of these assets should go on producing income forever (with ups and downs, of course), so you’ll have a fair pension already, too.
With this strategy you’re like the famous old-time Southern gentleman – you NEVER touch your capital, you only live off the income.
If I was at all young (say under 50), I wouldn’t try living off £410,000 for the rest of my life, even if I didn’t touch the capital. It’d be more sensible to aim for your salary plus 25%, and to reinvest the excess, to give yourself a margin of safety. You’d also want to take into account tax differentials between the different asset classes. (Dividend income is tax-free for lower-rate tax payers, for instance, so you may ‘take home’ more than you did at the office!)
Savings and salary working together
While you’re still saving, the income-producing assets you’ve already bought will already be contributing directly to your bottom line, too. For instance, if you’ve a £100,000 portfolio of shares, dividends could add £5,000 to your income buying war-chest every year. It’s yet another example of compound interest working in your favour.
What about inflation? Won’t I need more than my salary in 10 years time?
Good point. What’s more, you’ll need an income that is keeping up with the inflation rate to maintain your purchasing power – or better yet, increasing with wage inflation, to keep up with the neighbors.
It’s certainly possible to achieve the former with shares and property, since in the long-term dividends and rent will keep up with inflation. You won’t want too much in the way of cash or government bonds, since the income produced will hardly cover inflation, and will need to be largely reinvested. You’ll need to reinvest a significant portion of your corporate bond income, too (perhaps 30-50%, if you’re getting say 6% a year on it and inflation is around 2.5%) to stop its value being eroded over time.
In terms of your target income, it will definitely go up over time. Concentrate on the ‘riskier’ assets such as shares and property in the early years, since the income they produce should also go up over time. Like this, in practical terms your target isn’t racing way from you.
Incidentally, if you’re trying to achieve financial freedom by saving in cash alone, you’re doomed – your income almost certainly won’t be big enough to allow you to save enough to make up for the corrosive effects of inflation, even in if you stash it all away!
Escape from the rat race does not come cheap, and Monevator.com isn’t about pretending that it does. To return to our example of replacing a £25,000 salary with passive income, if I invested mainly in shares and rental property and only diversified heavily into fixed income such as bonds in my final years of saving, I’d plan on investing around £7,000 a year into shares for 25 years, assuming a pretty aggressive inflation adjusted annual return of 7%. (Handily, £7,000 is just under the annual ISA limit, so I could keep all my savings safe from the taxman).
I’m a saving ninja, and that would be a tough but achievable goal for me. But it won’t be for many, I realise – which is why most people you know will still be working at 70. If you want it enough, you’ll find a way (I’d suggest a second income stream as an ideal way to start).
On a more positive note, if you can increase your annual savings as your salary goes up over the years, you’ll bring down the total years required. Bonuses, inheritances, and wins on the horses can all be deployed to buy you a bit more of your precious salary-replacing income. And some people will already have savings they can use to start buying salary-substituting assets today.
Income or capital – choose whatever works for you
Some people will always respond more readily to a ambitious concrete targets such as ‘making a million’, and for them, the salary replacing strategy is going to sound too pedestrian. That’s fine, whatever works for you. I hope, however, that the idea of investing for income to achieve financial freedom has at least struck a chord with some of you, and look forward to receiving a postcard mailed on a ‘workday’ from a tropical island in a couple of decades’ time!
Further reading:
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