At some stage in your investing journey, you may experience a situation where your investment returns surpass your active income (non-investment income). The first time this happens, you may feel excited as you imagine the possibilities. But you likely won’t quit your job just in case it was a fluke.
However, after several years of your investment returns surpassing your active income, you will develop a lot more courage to do something new.
Perhaps you might finally ask for that well-deserved sabbatical without fear of your year-end bonus getting slashed. Or maybe you’ll have the guts to start severance negotiation talks so you can pursue a new career.
The power of compound annual returns is why you should save aggressively and invest for the long term. It is also why you need to think twice about splurging on big-ticket items like a car you don’t really need.
That $40,000 car you bought 10 years ago would be worth around $150,000 today if it was invested in the S&P 500.
Differentiate Between Investment Returns And Investment Income
Since I began working in finance in 1999, I’ve always had my mind set on generating investment income to eventually cover my desired living expenses. Getting into work at 5:30 am and leaving after 7:00 pm every day in a high-pressured environment for decades was not sustainable.
When I left in 2012, I had about $80,000 a year in total investment income of a total net worth of about $3 million. Back then, I dared not count on investment returns to pay for my lifestyle. We had just gone through a gut-wrenching recession and there was a chance we could go right back.
Further, counting on investment returns to fund expenses would require withdrawing principal, which I didn’t want to do. A decent portion of my investments was in growth stocks that produced no dividends. I was also still in my mid-30s and believed there was further upside to risk assets.
Therefore, I wrote the post, The Ideal Withdrawal Rate In Retirement Touches No Principal. The post helped motivate me to live frugally. I wanted all of my investments to continue compounding during an emerging bull market.
I’ve followed this strategy since leaving work in 2012. As a result, my original retirement nest egg has grown and so has my investment income. Now it might be time to change strategies.
Time To Live Off Investment Principal?
After a 10-year bull run, perhaps the easy money has already been made. Valuations are expensive, the Fed plans to taper, and we haven’t had a 10% correction in a while.
Even Vanguard is estimating only a 4.02% annual return for U.S. stocks over the next 10 years. The estimate seems low, but it could certainly happen, especially if there’s another bear market during this time.
Therefore, it might make sense to finally cash in some of the gains to live a better life. If a stock market crash does happen, you’ll be pleased to have utilized your investment returns for things and experiences. Dying with too much money would be such a shame.
Instead of just arbitrarily selling off investments to fund your retirement lifestyle, you could simply raise your safe withdrawal rate.
Case Study Of Living Off Investment Returns
Let’s say you believe in the Financial Samurai Safe Withdrawal Rate Formula = 10-year bond yield X 80%. As a retiree, your average withdrawal rate over the past five years was 1.5% to ensure that you didn’t draw down any principal. With a $3 million portfolio, you were living off $45,000 a year in gross income.
However, during these five years, your investments appreciated from $3 million to $5 million. They did so due to a 10.8% compound annual return. If you continue to withdraw at 1.5%, you will be able to live off $75,000 a year in gross income.
$75,000 is more than enough income to live a comfortable retirement lifestyle. You don’t need that much money. But you’re older now and feel like you might die with too much. Given you were confident enough to retire with $3 million, the past five years feel like you’ve won five consecutive lotteries.
Not only have you been able to do whatever you’ve wanted for the last five years, but you’re also $2 million richer! With five years less life to cover for, your desire to spend more has increased.
The YOLO economy is calling your name.
Cost To Fund New Initiatives
Next, you want to rent the Symphony Of The Seas Ultimate Family Suite for an around-the-world cruise. The cost? $20,000 a week for 10 weeks!
Although $200,000 is a lot of money, the suite is 1,346 square feet and large enough to comfortably accommodate your two grandkids. It would be the time of all your lives!
The total cost to fund these two items is $500,000, for a one-time withdrawal rate of 10% ($500K / $5 Million). If you consider taxes, then perhaps you really need to withdraw closer to $700,000. But let’s just use $500,000 for simplicity’s sake.
After the adventure is over, you’re now left with $4.5 million, or still $1.5 million more than you need.
You decide after spending so much money so quickly, you should take a break and go back to normal. Therefore, you adopt the FS safe withdrawal rate formula again and withdraw at 1.1% since the 10-year bond yield has declined.
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. All hail the benefits of a glorious bull market!
At What Point Does Work No Longer Matter Due To Investment Returns?
As I transition back to retirement by 2022, 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 2012. In addition, the active income I do make doesn’t do much to stem any losses.
For example, let’s say I lose 10% on a $5 million portfolio. That’s a $500,000 loss. Even if I worked really hard for several months to make $50,000 online, I’d still be down $450,000. Losing $450,000 feels the same as losing $500,000. Terrible. Therefore, spending precious time to make $50,000 would make the situation even worse.
On the flip side, let’s say I return 20% on a $5 million portfolio in one year. That’s a $1,000,000 gain. Even if I take on some consulting projects to make $100,000, a $1,100,000 gain doesn’t change our lifestyles one bit. We comfortably live on much less each year.
Therefore, there has to be some sort of crossover point where 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. You don’t care how little you get paid because you’d do it for free.
If you’re a regular reader of Financial Samurai, I think you can tell I love to write and share my thoughts. Writing posts like, If You Want To Naturally Be Nicer, Get Richer, isn’t going to make me money. But human behavior is an interesting topic to me so I write about it anyway.
The Investment Returns Crossover Point
I believe there are two conditions an investor must achieve before they can drop active income due to investment returns. Again, we are differentiating between investment returns and investment income. Once you generate enough investment income to cover your desired lifestyle, you can leave immediately.
Condition #1: At Least Three Years Of Outperformance
If your investment returns are greater than your active income for at least three years in a row or four years out of the last five years, I think you have the green light to take things down a notch.
Three years helps minimize the chances that your investment returns are not a fluke. And given bear markets (-20% sell-offs) tend to happen every 3.5-4 years, I use the benchmark of four years out of five years to account for a couple of bad years.
If your investment returns are greater than your active income for five years in a row or five out of the last seven years, you should be able to completely retire if you want to.
Condition #2: Investments Equal To At Least 10X Your Annual Active Income
In order for your investment returns to generate more than your active income for three years or longer, you likely need a sizable investment portfolio that is 10X or greater than your annual active income. For example, if you make $100,000 a year, you would likely need at least a $1 million portfolio for a chance to generate $101,000+.
To generate $101,000 in investment returns on a $1 million portfolio would require a 10.1% return. If your entire portfolio is in the S&P 500 and the S&P 500 returns its historical average of 10.2%, then you’ve got a decent chance of outperforming your active income.
However, if Vanguard’s lower return assumptions for stocks and bonds come true, then you will likely need an investment portfolio at least 20X your annual income until you no longer have to work. 20X your annual income is a key metric because it is my recommended net worth target to shoot for before retiring.
Using a multiple of income is better because it keeps you motivated to save and invest more as you make more money. We all tend to make more the longer we work. Further, using a multiple of income is preferable to using a multiple of expenses because it also keeps you honest. You can’t take a shortcut to financial freedom by slashing your expenses.
Once these two conditions are met, you should be able to reduce your work hours or eliminate them altogether. Further, these two conditions are scalable, no matter how much money you have.
How Long Will It Take Investment Returns To Surpass Active Income?
The length of time it will take your investment returns to surpass your active income will depend on your saving rate and your rate of return. Obviously, the higher your saving rate and rate of return, the greater your chance of succeeding.
Given I believe your capital needs to reach about 10X your annual gross income in order for your investment returns to regularly surpass your active income, let’s do some math.
Example #1: 20% Saving Rate
If you start with nothing and save 20% of your annual gross income each year, in 18 years at a 10% compound annual return, you will have accumulated 10X your annual income. In the 19th year, if you continue to get a 10% return, your investment return will have surpassed your static annual income.
If your rate of return is only 5%, then you will accumulate 10X your annual income in 25 years. If a 5% rate of return continues, then unfortunately, you will have to save and work for 36 years to finally see your investment returns surpass your annual income.
Example #2: 50% Saving Rate
If you start with nothing and save 50% of your annual gross income each year, in 11 years at a 10% compound annual return, you will have accumulated a little more than 10X your annual income. In the 12th year, if you continue to get a 10% return, your investment return will surpass your static annual income.
If your rate of return is only 5%, then you will accumulate 10X your annual income in 14 years. If a 5% rate of return continues, then you will have to save and work for 22 years to finally see your investment returns surpass your annual income.
The Likely Time Range
Saving 20% of your annual gross income each year really is the minimum amount I recommend everyone shoot for. Ideally, you will eventually make enough money to get to a 50% saving rate.
With a 20% – 50% saving rate and a 5% – 10% annual return assumption, it will likely take between 11 – 25 years until your investment returns steadily surpass your active income. Of course, if your income declines towards the end, then you can achieve this milestone sooner as well.
For me, it took about 15 years to regularly earn a greater return from my investments than my last year of working.
Living Off Investment Income May Be Harder In Normal Times
Generating enough investment income to cover your desired living expenses may be harder than generating high enough investment returns to cover your living expenses.
For one thing, you need to accumulate a lot more capital given interest rates are lower. You’ve also got to be disciplined enough to not touch principal. Finally, you may have to shun many growth stocks and equity real estate investments that produce no income, but may provide a greater return.
In contrast, if there is a raging bull market, then living off investment returns may be much easier. You won’t need as much capital to fund your lifestyle if your $1 million portfolio is returning 25% a year. But to generate $250,000 a year in investment income will require a $12.5 million portfolio with a 2% yield.
The reality is investment income and investment returns are intricately tied together. The logical thing many people do who no longer want to work is change their investment composition towards less risky, more stable, income-producing investments once they’ve reached their ideal number for retirement.
For example, ~40% of my net worth is in real estate versus ~30% in stocks because I want less volatility and more passive income. I’ve also got another 5% or so in individual AA-rated municipal bonds. The rest of my net worth is in private equity and private real estate investments.
When I was in my 20s and 30s, stocks accounted for 50% – 90% of my net worth. Losing 30% of my net worth in six months was OK because I could easily make up for my losses with my income. Today, not so much. Time is much more precious now that I’m older.
There Is A Level Of Capital Where Nothing Matters
Let me end by warning you there is a level of capital where you may lose all motivation to do anything.
In 2012, I was starting to get apathetic about making more money, which is one of the reasons why I left banking. At the time, my net worth equaled about 10X annual income and 40X annual expenses.
After such a long and relentless bull market, my apathy has returned. Yes, there were two massive spikes of motivation after each of our kids were born. But it has settled down now. If our investment returns were poor since 2012, I would be feeling the opposite.
Once your net worth is over 20X your annual income or 50X your annual expenses, tremendous apathy begins to take over. Once your net worth gets to over 40X your annual income or 100X your annual expenses, that’s when you start completely checking out. You may start constantly thinking to yourself, “F this BS!”
Therefore, 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.
If the strong returns in risk assets continue, eventually, productivity will decline. In that case, the only people left to do the work will be non-investors and new graduates.
I’d love to hear your thoughts on how you would use investment returns, not investment income, as a gauge for whether to work as much or not. With investment returns so strong for so many years are you getting demotivated to work as well?
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