"When I was young I thought that money was the most important thing in life. Now that I am old I know that it is."
- A quote attributed to Irish writer Oscar Wilde
THE THEORY of how to achieve financial independence, no matter how old you are, is relatively straightforward. Build up a big enough pool of financial assets like stocks and bonds, and you will start receiving a stream of dividends and coupons that you can live on.
Once this stream of passive income exceeds your expenses, you don't have to worry about working for money anymore.
Costs of living might still go up, and the vagaries of the business cycle bring your passive income down if companies are forced to cut dividends. But invest carefully, and the income stream you get will rise through the years and perhaps even exceed inflation.
Some people think they will never achieve this happy state of affairs. They think they need to be making six figures a year. Or they think they need to slog away at a corporate job for 30 years before they can retire.
This isn't true.
The key to financial freedom isn't about a high salary, though that certainly helps. Nor is it about being an investing genius.
Rather, as we demonstrate in today's column, it is entirely a function of one's savings rate.
The intuition is simple. The less you can live on, the less you need to generate in passive income to fund your life, and the fewer assets you need to retire.
Get your savings rate above 70 per cent, and there's a good chance that you can be financially free in 10 years, assuming you invest all the money you didn't spend.
It doesn't matter whether you are earning S$3,000 a month or S$30,000. The only catch is: How much can you live on?
You can be earning relatively little but still be able to retire in 10 years. Or you can be chained to your job with handcuffs of gold and have to slog away for the next 50 years.
The freedom formula
Imagine, for the purposes of this column, that you are taking home S$4,000 a month after employee Central Provident Fund (CPF) deductions.
According to Ministry of Manpower statistics as of June 2015, the typical person aged 35 to 44 is getting that after averaging out annual bonuses. This age range also happens to be where earnings peak.
(For those taking home S$4,000 a month in their 30s and 40s, employee and employer CPF contributions should amount to another roughly S$2,000 a month. We will come back to CPF later.)
So for now, you get S$4,000 in the bank every month.
How much do you spend?
Based on the last household expenditure survey conducted over 2012 to 2013, the typical Singaporean household, made up of two individuals making a combined S$8,000 (a figure including employer CPF), spends a little over half of that amount every month.
The survey did not account for spending on loan repayments.
Let's assume this spending is kept minimal because people bought flats within their means, and they decided not to drive.
So your total spending might be, say, 60 per cent of your S$4,000 take-home pay. This means you are spending S$2,400 a month, or S$28,800 a year.
This leaves 40 per cent for savings and investments, or S$1,600 a month, or S$19,200 a year.
Without taking the CPF lifelong annuity that kicks in at age 65 into account, when can your financial assets generate enough for you to retire?
Assuming that your savings and investments yield a conservative 3 per cent a year, it will take a full 31 years before they compound to S$960,000. At that level, you will generate exactly S$28,800, the amount you are spending now, on that 3 per cent a year yield.
Meanwhile, we assume any increases in the cost of living are balanced out by similar increases in your salary.
So at a savings rate of 40 per cent and a yield of 3 per cent, it will take exactly 31 years before your dividend and interest income exceeds your expenses, thus making you financially free.
You can read this from the bolded figure "31.0" in the attached table that sits at the intersection of a 3 per cent yield and a 40 per cent savings rate.
Or you can see how your assets compound in the manual calculations in the second table.
Only the savings rate matters
Here is the crux. Only your savings rate matters. You can work the numbers out yourself in an Excel spreadsheet.
You can plug in a salary of S$10,000 a month. But if you can only save 40 per cent of that, and you can only generate a 3 per cent return on your assets, it will similarly take 31 years before your returns exceed your expenses to make you financially free.
By the end of 31 years, you will have S$2.4 million generating S$72,000 of passive income a year, or S$6,000 a month - the amount you spend.
If you could live on, say, S$5,000 a month right from the beginning of your savings journey, you have retired much earlier.
It only takes 23.4 years for passive income to exceed expenses, at a 50 per cent savings rate and a 3 per cent yield. This figure is also bolded in the table.
To get that number, we assume that our high earner of S$10,000 a month spends S$5,000 a month and also saves the same amount.
By the end of the 24th year of compounding savings he will have S$2.07 million in financial assets.
This generates S$61,000 a year at a 3 per cent yield, or just over S$5,000 a month.
It gets better.
At a 60 per cent savings rate and a yield of 3 per cent, it will just take 17.3 years before expenses are paid for by passive income.
At a 70 per cent savings rate with the same yield, we are talking about just 12.1 years of work before one is financially free.
So by increasing your savings rate from 40 per cent to 70 per cent, you have shaved off some 19 years of the time you need to work.
Yield matters less
But you can invest well, you say.
You claim you won't just get a 3 per cent yield. You can get 5 per cent.
Now, achieving a 5 per cent yield consistently over a long period of time is not an easy feat.
To put the difference in perspective, S$10,000 a year invested at 3 per cent over 20 years will get you S$269,000.
If you invest that amount every year at a 5 per cent yield, you will end up with S$331,000, a full 23 per cent more.
But assuming you can do that, how much time will you save before your expenses are covered by your income?
At a 40 per cent savings rate and a 3 per cent yield, it will take 31 years as we noted previously.
At a 40 per cent savings rate and a 5 per cent yield, it will take 18.8 years before one is financially free.
Yes, you do save 12 years. But you are basically assuming that you can continue to generate 5 per cent returns of the entire sum of your financial assets, every year, for your entire retirement.
If half your assets are in cash yielding nothing, this means you need a 10 per cent return on the remaining assets to have a 5 per cent return.
That's a pretty tall order. In the current environment, safe bonds yield just 2.5 per cent a year. You will be taking plenty of risk.
High risk, high returns, you say.
But that is far from true. High risk not only carries a chance for higher returns. It also carries a chance for significantly lower returns.
Make the wrong yield assumption on your retirement planning, and you might be in for a nasty surprise.
Instead, you could have increased your savings rate from 40 per cent to 60 per cent, assuming a 3 per cent yield. he number of years you need to save will drop from 31 to 17.3, as noted earlier.
This beats the uncertain assumption of having a 5 per cent long-term yield.
How to save time
Based on the table, the strategy to gun for early financial independence is clear.
You can either increase your yield, or increase your savings rate.
For most people, it is easier to focus on improving their savings rate, either by increasing their salary or by cutting back on their spending - or both.
A few crucial observations can be made.
First, at very high savings rates of 70, 80, and even 90 per cent, the time to financial independence is dramatically shortened.
Take the 80 per cent saver, for example. He will achieve financial independence in just 11.3 years assuming an ultra-conservative yield of 2 per cent a year. If that yield increases to 3 per cent, he will hit his goal in just 7.5 years.
Second, in a low interest rate environment like where we are now, improving one's savings rate has a dramatic effect.
If you only manage to get a 2 per cent return on your assets, the first 10-percentage point increase in your savings rate from 30 per cent to 40 per cent will save you 14 years. The next move will save you 11 years, and the next, nine years.
By contrast, if you can get a 4 per cent return on your assets, moving from a 30 per cent savings rate to 40 per cent will save you seven years - still substantial, but not as dramatic as the previous example. The next move up to 50 per cent will save you six years, and the next, five years.
(Perhaps adhering to this will exemplify the paradox of thrift theory: A low interest rate environment makes people intuitively understand that they need to save more to retire faster, but the act of saving more depresses the economy.)
Third, most conventional retirement plans assume one has 30 years to save.
Working backwards, and assuming that most conventional retirement plans assume higher yields, we can infer that the people who are following these plans are possibly operating on savings rates of 30 per cent or less.
That is way too low, if you are determined to achieve financial independence early.
Shaded in the table are numbers around 10 years and below. The permutations are clear: Anybody saving 80 per cent of their income at a 2-2.5 per cent yield or more will be able to see the light at the end of the tunnel within 10 years.
The same applies to people saving 70 per cent at a 3-4 per cent yield and up, or saving 60 per cent at a 5 per cent yield and up.
If you are the extreme sort that can achieve a 90 per cent savings rate, and manage to live on relatively little, you can, in theory, be financially free in just a few years.
Whether you will retire upon achieving financial independence is another matter altogether. But at least you will bask in the knowledge that you don't really need to work anymore.
The power of habit
Increasing one's savings rate is always easier said than done.
Many people will be burdened with financial commitments they cannot easily shrug off. Others will find ways to cut costs without making too many sacrifices.
Nudging up the savings rate can result from eating out less, or splurging less on branded goods and expensive holidays. Another key expense is the car. Going car-free will probably lead to one's savings rate rising substantially.
But other expenses on loved ones might be non-negotiable.
Along the way, people will wonder if they are sacrificing their quality of life. It's a valid question.
Approaching the question of cutting expenses always involves rethinking what one wants out of life.
The converted in the low-cost way of life will preach that the finer things in life are not paid for, and memorable experiences can be obtained at value prices. The danger in upgrading oneself to a higher-spending lifestyle is how one will get used to the life and will not be able to downgrade.
So one can get habituated to ways of efficient, low-cost living, they say.
Psychological studies of how habits form demonstrate how difficult they are to break. If you are used to living cheaply, you will seldom be tempted to splurge. You might even enjoy the occasional expensive restaurant meal that little bit more.
Others will insist that life is short, so why bother? One can't take money to the grave.
There is nothing wrong with thinking thus. Whichever your views on spending, personal finance is always about making a personal choice.
Hopefully, upon seeing the dramatic effects that increasing the savings rate has on your path to financial freedom, you will be motivated to nudge it up.
Don't forget CPF
Which brings us our final point: You are saving more than you think.
Singaporeans have the luxury (or curse, as some say) of being tied to the CPF system.
Along one's entire working life, contributions are made to one's Ordinary Account (OA) meant for housing needs, Special Account (SA) meant for retirement needs, and Medisave Account (MA) meant for medical needs.
The government has said before that 70 to 80 per cent of young people now will be able to meet their minimum sum requirements by the time they retire, even after withdrawals for a home.
Meeting the old minimum sum - now called the full retirement sum - translates to a typical payout of S$1,200 to S$1,300 a month in today's dollars, for as long as you live.
This will already cover basic hawker food and public transport needs, with money left over for restaurant meals and entertainment.
Meanwhile, your MA will help with medical expenses especially in our twilight years, and your OA contributions have ensured you have fully paid up your house by the time you retire.
But for CPF to work as projected, you have to assume a traditional working life from age 25 all the way to 62 or 65, with contributions all the way. And you must not overspend on a home.
As we discussed in last week's piece ("Rethinking retirement", Jan 9, 2017), one's working life might not be as continuous as one thinks.
Better, then, to boost that savings rate and cultivate prudent habits of spending and saving while one can.
After all, so long as you save substantially more than you need to spend, you don't really need to earn much for too long.
This article was first published on Jan 16, 2017.
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