Friday, March 8, 2013

Margin of Safety with Financial Independence

I know I'm a little early on this since I have a few more years until I reach financial independence; however, it doesn't hurt to at least have the ideas floating around beforehand.  There's a few school's of thought on early retirement.  Some people prefer to have all their expenses covered from investment or other passive income sources while others prefer to have a good chunk of their expenses covered and have the rest covered by part-time work whether at the same job but scaled back or a new one altogether.

I'm in the all expenses covered camp.  I like the job that I currently have except for having to be gone from family due to work for a good chunk of the year.  There's no way I'll be keeping this job after I reach financial independence; however, I have thought about working at some small businesses near my house as well as teaching whether in the public school system or occasional seminar type classes on personal finance.  It's still a few years away so I have time to decide.

Back to the topic at hand, if you choose to have all your expenses covered you need a margin of safety.  A margin of safety is how much of difference between meeting the actual value and the minimum requirements.  When designing a building, I'd hate to know that each floor was designed to hold 20,000 pounds and no more, when the typical load is 20,000.  There's no margin of safety there, you could bring in one extra chair and cause it to fail.  The margin of safety I'm after though is the difference between my investment/passive income and my expenses.

A margin of safety is the only real way that you can plan for all the variables that come into play when you're looking at a potential retirement span of 50-60 years.  Inflation is unknown; dividend growth is unknown; possible dividend cuts are unknown; medical expenses are unknown; potential emergencies such as a roof leak or a/c breaking as well as many others. So a margin of safety is our way of combating the unknowns.

My total expenses in 2012 came to $20,000 and some change.  So at the bare minimum I'd need my dividend income to provide $20,000 annually.  As of now my plan is to add another 10% for the margin of safety which is another $2,000.  From here I'll add another $3,000 to cover travel expenses because I do expect to be travelling more.  So with the margin of safety my required dividend income is $20,000 + $2,000 + $3,000 = $25,000 in 2013 dollars.  My plan is to also have at least 1 year of expenses saved up in cash in a savings account; however, that's likely to change depending on the whether we carry a mortgage or not.

Have you thought about how much cushion you want?  How much are you aiming for?  Are you planning on seeking out part-time work to augment your passive income?

22 comments:

  1. One thing I think about (a lot) is what is the expected rate of increase for my expenses, and am I being conservative enough with my assumptions about investment returns. For example, while the CPI may be only 2% per year, my medical insurance premium has been increasing at 8-10% for several years. And that line item is a big percentage of my expenses.

    So when I think about margin of safety, I have a budget that is extremely aggressive on how expenses will increase and very conservative on investment gains.

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    1. Tim,

      Medical expenses are probably the biggest curveball because they are way too hard to predict. I'll probably get on my wife's insurance because she will continue to work. Being aggressive on the expenses increase and conservative on the investments is a good idea. And if it works out well, you can be pleasantly surprised and have some extra spending money. Insurance is on my list to check out as FI gets closer to see what it'll cost for me on my own versus being on my wife's. Great point!

      And thanks for stopping by!

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    2. My pleasure. I have you in my RSS feed, so I will be back to pester you in the future :)

      And FYI, I wrote a post yesterday where I made a slight dig at "Passive Income" but it was NOT in the context of what you are doing here. I was talking the empty promises that i see being made on the internet by people claiming you can get rich by working 4 hours a week - they say, "just sit back on the beach and collect your $100,000 a month in adsense revenue. and here is my Jedi training manual on how to do it. It only costs $995, but it is worth $10,000."

      ...Tim

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    3. Tim,

      Feel free to pester me as much as you want! ;) I love having visitors to the site to bounce other ideas off of. The open dialogue of the blogging community is great.

      I wish it was that easy, but we probably wouldn't have as many financial problems in this country if that was the case. Unfortunately the only people that are getting rich off those promises are the ones selling their "guide".

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  2. Once my annual dividend income exceeds my annual expenses, then I will likely re-assess my life situation and determine whether some form of retirement makes sense. However, even if I favor the retirement route, I would probably try to work for another year or two after reaching the "crossing point" to build up the margin of safety you mentioned. One thing I have noticed in my long-term dividend income projections is that a few extra years near the end (i.e., after 20-30 years of investing) can have a huge effect because you're in the steep, exponential part of the growth curve.

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    1. DGM,

      That's the issue I have with early FI is that you lose the compounding effect that doesn't really show up until years down the line. To counter this I'm still contributing to my Roth IRA and 401k to allow for long-term compounding and won't plan on tapping that until the traditional retirement age. I should have around $150k in traditional retirement accounts by FI so giving those an extra 25-30 years to compound will help out for the later years when the medical expenses become a bigger burden.

      Thanks for stopping by!

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  3. I'm in the "have a good chunk of expenses covered" camp. Just letting dividends grow and making up the difference isn't all that scary to me.

    In reality, I plan to have some sort of "work" (until I get sick of it) and let the level of passive income grow. I probably won't "retire" until my future kids are done with college - covering my family's expenses with some type of income producing activity, most likely targeting a 0% savings rate.

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    1. Headed Home,

      I do plan on working in some form, but it's going to be on my own terms. It won't be the job that I currently have because I'm away from home way too much and that's not going to go over well once I reach FI. The whole point of me reaching FI at a very young age is to allow me the freedom to not only see my family and friends more often but to also pursue other interests. Any future work after FI is going to be something completely different from what I do now.

      Thanks for stopping by!

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    2. I completely understand your goal of having 110% of expenses covered. It makes perfect sense. I would just rather not spend the extra year or two slaving away and being gone from home/family. Once you're at 50-75% covered, the growth in passive income will catch up with expenses in the not-too-distant future. It's riskier, sure...but to each his own on this crazy journey.

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    3. I think due to my high savings rate an extra year will make a huge difference. Currently I'm on track to contribute over $70k this year to my FI portfolio. That will go a long ways towards increasing dividend income or paying down the mortgage. Of course that's liable to change once I get closer to FI because I might just get the attitude that it's close enough and I need out. There's times where my job is a real grind and I can't stand it anymore. If my journey to FI was longer then I'd probably call it good enough about at less than my expenses and rely on the DG a little bit more to make up the gap.

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  4. I am in the covered expense camp, however, I don't actually plan on "retiring". It instead will allow me to persue other passions unrelated to my day job, but also have the potential to bring in additional income as well. I think once I reach the financial independence point I will probably work full-time for another year or two as I plot a successful transition, thus helping to create that margin of safety.

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    1. W2R,

      I'm definitely going to have the full expenses covered. But like you completely retiring and not working in any form won't be in the future. As I mentioned I've thought about teaching to try and make a difference but that will depend on if I can find the right school. The date of FI will also depend on where we're at in our mortgage because there will be one coming in the future and I'm leaning towards getting that completely paid off. I think after I get my expenses + 10% covered I'll be looking at one more year and that will be almost completely devoted to building up cash savings and paying down the mortgage.

      Thanks for stopping by!

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  5. I am aiming for 5k monthly. Not there yet by far. But working on it hard. I also want to have all expenses covered in lieu of part time job. I want to have a job only as a job I just want to work, not because I have to work. I can see my account growing fast, so will see how long would it take to get there (I do not have enough data to make predictions, maybe at the end of this year).

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    1. Martin,

      I'd love to get to $5k monthly but I don't think I'll stick around that long. It's hard to predict when I only have a little over a year of data and about 5 months of that was aggressively paying off debt. If I end up making a lot more progress on the dividend income then sticking around a little bit longer to get another $500-$1k monthly would probably be in the cards.

      Thanks for stopping by!

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  6. Howdy,

    If you have $20,000 in expenses, don't you need at least $25,000 in income given taxes? I say shoot higher like $30,000+!

    Sam

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    1. Sam,

      True, I forgot about taxes which is strange because I account for them in almost every other calculation. Ooops, we'll just add that to the list of things to try and account for. So you're right that would be around around $30k given the current tax environment. Of course I expect to be able to supplement my income through some form whether part time work/consulting and hopefully the blog. When you have every day free to do as you please I don't think it'd be that difficult to earn another $3-5k post taxes each year.

      I sometimes forget about the taxes on my dividend income because I account for it in the withholding from my paycheck. My income fluctuates so much from paycheck to paycheck, I'm talking $1k post tax and then $4-8k on the next, so the withholding is really high on the large paycheck and makes up for the taxes for dividends right now.

      Thanks for stopping by!

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  7. I am aiming for all expenses covered. I can't call myself financially independent if I have to show up for work in order to pay any of my bills. I'm thinking about cushioning myself in several ways.

    1) 1 year of expenses saved as a cash cushion. I'm currently building that.
    2) Building up an additional 20-25% income above and beyond my current expenses.
    3) Move to a lower cost of living area. I could move back to several places that I used to live and cut my expenses by 33%.

    There will have to be a significant reassessment of my lifestyle desires as I get closer to the FI boundary line. If I'm going to keep working, I may decide to expand my expenditures so that I can do more of what I want in life. if I don't want to keep working, then moving some place cheaper will become much more attractive.

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    1. MyFIJ,

      I think that's a solid plan, although like Sam mentioned, don't forget the taxes. Right there that means an extra 15% above expenses and any margin of safety would be required.

      Luckily we have several expenses that will get pared down once I can be home all the time. Our grocery budget right now is way out of whack but that's due to cooking for one on her part and my eating out of a box way too often.

      I've thought about getting a part time job or a full-time job where I can have more flexible hours. That will be used as extra savings to build up the margin of safety and allow for more fun money while still working and in retirement.

      Thanks for stopping by!

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  8. Nice post Pursuit. Frankly, I hadn't actively started thinking about this topic till I started blogging.

    My goal, like many of the others is full expense coverage, plus a buffer of 20%. I estimated that previously to be about $50k.
    I want that to be fully covered before I think of anything else. I'm hoping to get near that mark in another 5 years. I don't expect anything material to change in my life at that point, but I'll probably be more relaxed about the opportunities I go after and less concerned about the monetary potential

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    1. Integrator,

      I still have some time before reaching FI but I think it's good to at least have an idea beforehand. I'd love to get it up to $50k but I won't be sticking around my current job long enough to get that much income from my dividends. I think I'll have some form of work and then let most of my dividends be reinvested.

      The best part about reaching FI is that it gives you the opportunity to either pursue something you truly love or take more risks with your current job because you aren't burdened by the financial ramifications.

      Thanks for stopping by!

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  9. I break the process into two goals. The first goal is enough to be FI on basics (housing, food, utilities, insurance, etc). Psychologically, this helps me see a shorter term goal that is more attainable.

    The second goal is to build the travel/fun stash for nice to haves. This is also a nice cushion, if the market isn't going your way.

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    1. MarkT,

      I think that's a great way to look at it. Right now I'm focused mainly on getting my expenses covered and once that happens then I'll have to take a step back and revisit the idea of how much cushion and play/travel money I want us to have. The extra will probably depend on whether I feel like working full time in some other field or not. It's hard to forecast where I'll be another few years down the line because if you'd have asked me 3 years ago where I'd be now, it wouldn't have been close to where I'm at right now.

      Thanks for stopping by!

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