assessing FINANCIAL INDEPENDENCE
overview
Planning for financial independence can be a complex task - in many ways this is because wealth is a nebulous concept. Often it is thought of as one’s net assets – that is to say, simply the value of one’s gross assets less liabilities. But in actuality true wealth is about cash flow generation and the extent to which one is liquid.
Living in a palatial estate but having limited access to liquid funds does not help meet expenses as and when they fall due – a person would arguably feel far from wealthy in such a situation despite the appearance of their surroundings. On the other hand, where one has income many multiples of that required for the household’s monthly expenditure, then they would arguably feel rather comfortable or wealthy.
In the end true financial wealth is having the ability to undertake whatever action one wishes. True total wealth is having the health, time and financial means to undertake whatever action one wishes.
As the name suggests, financial independence is all about having sufficient positive cash flow to cover required expenses – and ideally having that cash flow be generated passively with no ‘need’ for a salary income. Clearly, the magnitude of assets owned is correlated to the ability to generate cash flow, but we would encourage when planning for financial independence that focus turns towards cash flow requirements as opposed to simply the size of net assets per se.
Below we present a model that assists the conversation around planning for financial independence. Indeed, one of the key aims is to have the user appreciate the link between the cash flow required, the earning assumption on the capital base and the capital base required to sustain the given level of cash flow generation. An important consideration that the model demonstrates is that in a low interest rate environment the required capital base is much higher than it would otherwise be in order to generate a given income stream. Through scenario analysis one is able to see just how sensitive outcomes are to a given set of assumptions.
The model allows the user to ascertain the values around which an income stream may be generated. Indeed it can be used to answer:
What amount of capital is required to generate a given amount of income per year?
What rate of return is required in order to generate a certain amount of income per year given a set amount of capital?
How long will a given amount of capital last assuming a certain withdrawal rate?
the model
The model can be downloaded by clicking here.
The model is Excel based and requires the use of macros. Please ensure that the ability to run macros is enabled within the security settings.
Further reading
The Financial Services Institute of Australia (FINSIA) released a couple of reports on the thematic of sustainable retirement income. They help to clarify often misunderstood concepts that are critical when wanting to generate cash flow from a given capital base - be it in retirement or from the financial independence perspective.
When used in combination with the model above, they aid in providing a clearer framework within which one can understand the cash flow requirements needed for financial independence and moreover, how best to manage the risks and challenges inherent with such an undertaking.
Sequencing Risk - A Key Challenge to Creating Sustainable Retirement Income
How Safe are Safe Withdrawal Rates in Retirement?
The ASFA Retirement Standard benchmark is also a valuable resource, located here.
Other considerations
We are able to provide more advanced models that account for different cash flow frequencies, tax and employ the use of Monte Carlo simulation to project success rates for given model parameters. Simply contact info@financialactuality.com for further information.