Most of us get into investing because we want freedom, whether it be freedom from the office, from traffic jams or from the drudgery of a mortgage. We want to be free from having to work for a living.
Why then are money-motivated books called things like The Millionaire Next Door
What many of us are really looking for is a replacement for our salary. The number on your pay check is therefore the number you need to beat.
If your salary arrived in your bank account no matter what you did, wouldn’t you be free? You could quit work the next day, if you wanted – or you could get a more enjoyable or meaningful job, work for charity, or do a dozen other more fulfilling things instead.
This post explains why and how I focus my investing on growing my annual passive income stream to replace my income, rather than concentrating on my net worth.
Note: If you’re an American or European investor, please do keep reading. The principles of good money management are international! 🙂 Just mentally swap the £s for your currency and scale up or down as appropriate.
Why target income instead of capital?
Generating a sufficient income to replace your salary is going to require some serious capital. There’s no escaping that fact.
But I believe there are some subtle benefits in targeting income rather than a capital sum when making your investment plans:
- Replacing a salary is a more tangible goal for many people. Having £1 million sounds like winning the lottery. Generating £25,000 a year sounds more feasible. We only achieve what we truly believe we can achieve.
- Better investment decisions. If you’re shooting for the stars, you’re liable to trip in the gutter by taking too many risks. If you’re building a portfolio of income producing assets, you’ll take a more measured view, reinvesting dividends over time and not being scared out by blips in asset prices.
- Asset allocation. There are plenty of income producing assets (I list a few below). By buying different ones as and when they appear cheap, you’ll build up a nicely diversified portfolio as well as buying more income bangs for your investment buck. Aiming for a capital sum could encourage you to chase whatever sector is currently hottest and likeliest to come crashing down.
- Reduce portfolio churn, taxes and dealing fees. This is a great hidden benefit. If you buy shares in a company with 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 to compound over the long-term or to spend later.
What assets produce income?
Plenty of assets grant you regular cash payments in return for holding them. They range from the very safe (cash), through bonds and property, right up to the very risky (such as out-of-favor small-cap shares that may or may not double in price, or cut their dividend, or go bust).
Other assets such as gold and other commodities, mining shares, and tech stocks typically don’t produce much income. Instead you hope for a capital gain.
In rough order of riskiness (and so higher long-term income as a reward), you could consider the following assets for your income portfolio:
- Cash
- Government bonds
- A private or state pension (if you’re old enough)
- High grade corporate bonds
- Junk bonds
- Regular savings into an equity-income investment trust or fund
- Investing in a stock market index-tracking fund (the UK FTSE is currently paying over 5%)
- 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 (arguably not actually that risky over the long-term, provided you can ignore the fluctuations in capital)
- Overseas property
- Exotic and specialist income plays (like Prodesse, the mortgage-backed security investment trust I bought)
- Investing directly in small private businesses for a share of the profits
These are just the pure investments – there are other options. For instance, you might create a second income stream, especially if it’s based on a hobby you’d enjoy doing once you’ve quit work.
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 should know roughly the figure required, rather than going after the rather nebulous idea of a million pounds, dollars, or whatever your currency of choice is.
Here’s an example income portfolio. Say you’re currently earning £25,000 as a salary. You might replace that salary with a portfolio containing 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), so you’d have a fair-sized pension on quitting work, too.
With an income strategy you’re like the famous old Southern gentlemen – you try NEVER to sell 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 to replace your salary plus 25% extra, and to reinvest the excess, to give yourself a margin of safety.
On the other hand, if you’re an adventurous type you may decide not to save any more money once you’ve left work and started drawing your investment income. You’re currently saving and investing a chunk of your current salary, remember – this money could go on living instead. In that case you’ll need less income than your current salary to live on. Risky, but each to their own.
You’ll also want to take into account tax differentials between different asset classes. Dividend income is tax-free for lower-rate tax payers in the UK, for instance, so you may find you ‘take home’ more than you did when working!
Savings and salary working together
While you’re still saving and building up your income portfolio, the income-producing assets you’ve already bought will contribute money that you can use to buy yet more income.
For instance, if you’ve already got a £100,000 share portfolio, then 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.
Never forget inflation
Won’t you need more than your salary in 10 years time, due to inflation?
Good point. 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 an inflation-proof income with shares and property, since over the long-term dividends and rent will likely keep up.
- You won’t want to hold too much cash or government bonds, since the income produced will usually hardly cover inflation, and will need to be 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 the target income required, it will definitely rise as you save towards it. 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, and you’ve more time to ride out volatility.
Incidentally, if you’re trying to achieve financial freedom by saving cash alone, you’re doomed unless you earn millions. Surplus income from an ordinary job almost certainly won’t be enough to enable you to save enough to make up for the corrosive effects of inflation, even in if you stash it ALL away.
Escaping from the rat race does not come cheap, and I’m not 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 the portfolio 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 in the UK, so I could keep all my savings safe from the taxman).
I’m a money saving ninja, and that would be a tough but achievable goal for me. But it will be too much for many people – 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 creating a second income stream is 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 time it takes. Bonuses, inheritances, and wins on the horses can all be deployed to buy you a bit more of that precious salary-replacing income.
Do what works for you
Some people will respond more readily to ambitious targets such as ‘making a million’. 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 I’ll look forward to receiving a postcard from you mailed on a working day from some dream location in a couple of decades’ time!
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