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Monday, March 27, 2017

An Alternative: Sustainable Spending

Posted by Robert on June 21, 2010

Before I started thinking about early retirement, I thought about the logical progression of my savings program. I currently spend about 50% of my paycheque and I save and invest the other 50% (including mortgage payment). The reason for spending relatively little is that I was brought up to be restrained, and not that I lack the imagination. I’d like to spend more, but I don’t want to be in a situation where I’m living month-to-month, even if my monthly spending were double what it is now.

Early on, I spent most of what I earned. As my earnings increased, my spending remained relatively consistent. When considering spending more, I felt that I would rather save and invest, so that I would have more financial stability. Finally, I realised that I was progressing toward the ability to meet monthly spending needs with investment income, which is another way of saying financial independence.

Wouldn’t it be great if my spending were sustainable? Suppose I spend $3000 a month. As soon as my investments produce $3000 a month of spendable income, my spending is sustainable. I no longer need to work to maintain my spending. On top of that, as I continue working, I can increase my sustainable spending amount. It is difficult to conceptualise a concrete plan using this approach because it has so many variables. Salary often increases over time. Investments may pay dividends, which are fairly consistent, or they may grow in market value, which is volatile. Spending can also fluctuate from month to month. But the main idea remains to increase spending only as investment returns make it sustainable.

Here is an example of how this might work. For our example, we’ll use a single man, John, who never marries or has children (to keep it simple). John starts out earning $30,000 per year (after tax). He spends $20,000 and is able to save $10,000.  We will assume that dividend-paying stocks pay a consistent 5% (re-invested) and we’ll ignore market growth. After 10 years, John has $125,778.92 in investments, producing $6,289 in dividends in a year. John’s spending has increased (with inflation) to $22,000 per year, but he’s gotten a couple of raises at work and now earns $40,000, saving $18,000. At the end of another 10 years, the investments are worth $431,282.68 and they produce $21,564.13 in dividends. John is basically financially independent after 20 years.

Now John can really start to increase his spending. Let’s suppose he gets a raise of 3% per year. The next year, he’ll earn $41,200; the investments will increase by $21,564.13 just from dividends; if he were to spend the same $22,000 and save the rest, his investments would increase by another $19,200. The total increase for the year ($21,564.13 + $19,200) is $40,764.13, which can produce $2038.20 in dividends. John should spend ($22,000 + $2038.20) about $24,000 this year. The following year, John earns $42,436 and his investments (at $470,046.81) earn $23,502.34. For this year, John can increase his spending by $2,075 (using the same approach as above), or $26,000. The last year in our example, John’s investments (at $509,985.15) produce $25,500 in dividends. He’s not living the high life yet, but his spending is increasing and it is sustainable. The market value is unimportant, since his income is from dividends, and losing his job or taking a year off wouldn’t affect how much he could spend, only his rate of increase. He’ll never have to go back to spending less. He can continue to increase his spending as long as he continues working.

If a person is disciplined with their spending, they should be able to reach financial independence relatively early. Once their spending is matched by their investment income, continuing to save allows them to increase their spending in a way that is sustainable. As such, the risks of not being able to work are totally mitigated and they will never have to return to spending less money.

Does this plan seem practical to you? Is this a viable alternative for people who could retire early, but who love their jobs?

Comments

7 Responses to “An Alternative: Sustainable Spending”
  1. Simon Pickard says:

    You assume dividends will always be paid. Just ask anyone in the Uk who has BP shares (1 in 7 pounds invested in the Uk) if this is a good plan.

  2. Robert says:

    Simon, you make a valid point. Dividends are not guaranteed. What are the alternatives? Employment income, where there is risk of losing your job (100% of income). You could buy bonds, where the risk is the issuer defaulting (even governments have done this). You could buy property, where there is risk of natural disasters and market crashes. And no matter what you do, your whole plan could be derailed by disability, death or war (forced emigration).

    So now that we’re finished being gloomy, I like the idea of income from dividends. If a company cancels their dividend (5% of my total income), I should have income from a number of other investments (assuming I have diversified) as well as the possibility of returning to work.

  3. George says:

    Even if it were 10% of your income, it shouldn’t kill your life, unless one is living too close to the edge.

    In the case of BP, if I’d owned some, I would have sold it on the day the rig sank. Fires are not unheard of events… leaking rigs are much worse and there’s complete uncertainty as to when the leak will be plugged, thus an open-ended liability.

  4. Adam says:

    I’ve been watching BP, as contrarian as it sounds – I am considering an entry point into this stock. I know this is a big black eye for BP, but really – I don’t think this megalith of a company is going anywhere.

  5. Dave says:

    I like this idea – slowly being able to check off specific expenses year over year – basically being able to know that at a certain point your food is paid for for the year (for example). When your final expense is paid for, you can be done working.

    – I’m a little leary of having 100% of my income coming from dividends as well, but I agree with what Robert says – I’d be much more diversified that way than my current situation with all income coming from employment.

  6. Robert says:

    Adam, you may be right, but you never know. Look at GM, as an example. Or Bear Stearns. Analysts say that BP has the money to fix their problem, but that regulatory and legal issues could drag on for years.

    Dave, I like your idea of checking off budget categories as they become sustainable. That’s a great way to measure progress.

  7. Steve says:

    I wish someone had told me about dividends when I was in my early 20s.

    Now as I approach 40 I think Dave’s plan is totally practical and I’m following a similar path. I love the idea of knowing that my dividends from Enbridge for example will at some point in the future fund my annual natural gas costs or that my Rogers dividend checks will fund my TV/Internet/Phone costs.

    The idea that my dividends from those companies whose services I use will be used to pay for those same services is incredibly satisfying.

    Simon makes the obvious point that sure, the dividend may be cut back or cut entirely but provided you have enough diversity of dividend paying stocks, it won’t wipe you cash-flow wise the same way the loss of a job would.

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