How far to financial freedom?

What you live off when you’re not working …

In our introductory meetings with potential new clients, we want to obtain a preliminary view of their “Net Investment Wealth”. It quickly gives us an idea of how far along the road to financial freedom or financial independence they have come and how far they have to go.

Net investment wealth is your net worth less your lifestyle assets. It’s the stuff available to live off when you are no longer earning income from your work.

To make the concept more concrete, consider Steve and Kate Wilson. Their assets and liabilities are shown below:

The Wilsons, despite a net worth of a little over $2.7 million, have accumulated only $95,000 in net investment wealth! Virtually all their net worth is accounted for by lifestyle assets i.e. their home and cars.

How much do you need for financial freedom?

If the Wilsons are in their late 30’s-early 40’s, and looking to work for another 20 years, a net investment wealth of $95,000 may not be cause for concern. But it is definitely a focus for a meaningful conversation.

However, if they are in their mid to late 50’s and hoping to retire within 10 years, there may be some major issues to confront. Because when the Wilsons retire, it is their net investment wealth and its hopeful growth that will be used to finance their desired lifestyle.

If they tell us that they want to spend around $125,000 p.a. in today’s dollars in retirement, a (very) rough rule of thumb is to multiply this amount by 25 times to obtain an idea of how much net investment wealth is required to support their lifestyle. In this case, required net investment wealth is $3,125,000 (i.e. 25*$125,000). This compares with current net investment wealth of $95,000 – a shortfall of $3,030,000.

What has to happen to accumulate this shortfall?

If the Wilsons are now aged 55 and wish to retire at age 65, assuming investment returns of 4% p.a.(after-tax and inflation) they need to save an average of about $250,000 p.a. in today’s dollars for the next 10 years. They better have a substantial income. However, if they are aged 40 and also wish to retire at age 65, the required saving reduces to about $69,000 p.a.

Such “back of the envelope” calculations will help you to quickly get a good idea what needs to happen for you to achieve your retirement or financial independence goals.

Net Investment Wealth: a “financial independence” indicator

Financial independence, that we equate with financial freedom, is achieved when you have sufficient net investment wealth to support your desired lifestyle, without the need to work. Work is a choice, rather than a necessity.

Your current net investment wealth provides a guide to how far along the financial independence road you have come. Together with other inputs, such as how much you would like to spend when you no longer wish to work, it can provide guidance to how far you have to go.

The simple analysis described above will highlight issues to address to increase the chances that you will achieve the financial future you want, such as:

• Do I need to save more? If so, how much?;
• Do I need to earn more income? If so, how much?;
• Are there structural changes I can make in my financial arrangements to increase my after-tax income and, hence, savings;
• Do I need to work longer? If so, for how long?;
• What sort of investment risk do I need to take to earn higher expected returns and, potentially, accumulate net investment wealth quicker? Am I prepared to take that risk?
• Is there scope to convert lifestyle assets to investment assets e.g. down size the family home?;
• Should I be changing my retirement expectations?

A focus on your net worth or total assets, in isolation, can give a false sense of your options for financial freedom. A heavy bias to lifestyle assets may give the feel and appearance of wealth but it is wealth that is unlikely to be consistent with aspirations for early financial independence.

And if financial independence at a particular age is a goal that is important to you, then knowing your current net investment wealth and having a plan that addresses how you are going to grow it is critical.