In my last financial freedom update, I briefly mentioned the concept of the crossover point. It’s a fairly simple, but motivating, concept that shows the point at which your passive income grows enough to meet (or just about exceed) your recurring monthly/annual expenses. In essence, it’s the point where you reach financial independence or FIRE (financial independence/retire early).
An Example of the Crossover Point
As an example, check out the image at the top of this post. The blue line represents growing passive income, while the red line represents annual expenses. For this hypothetical example, I assumed that the family was fairly frugal with $50k in annual expenses increasing with inflation annually. In year 1, this family generated $5k in passive income with the goal of compounding the income by 10% per year.
Assuming a perfect track record, the passive income produced will result in a crossover point at around the 32-year mark. As with any compound interest, the chart is slow to grow in the beginning, but a couple of decades in and the portfolio will really start to take off.
A Personal Example – Using Dividends
When shooting for financial freedom, the goal is to continually grow your passive income sources while keeping your expenses in check. In my case, I’ve chosen to accumulate publicly traded companies that have a history of growing their dividend.
The beauty of this strategy is that these companies, for the most part, pay a predictable dividend with a fairly predictable increase on an annual basis. Not only do you get a regularly occurring raise in your sleep, the extra money helps combat the erosive impact of inflation.
The icing on the cake is that eligible dividends get preferential tax treatment for early retirees. For example, in most provinces, you can earn up to $40k from eligible dividend income and pay little or no income tax (providing that you have no other reported income) and double if you can split the dividend income with your spouse.
As stated in my last financial freedom update, we are up to $48k in dividend income. With fairly consistent annual expenses in the $52-$54k range, we are getting close to the crossover point (ie. financial independence). While I don’t plan on retiring quite this early (I’m still 25 in my mind), it’s a reassuring financial backup plan if something were to happen that impacted our main income stream (ie. losing my job, poor health etc). It’s like being self-insured against financial risk.
You Don’t Always Need Early Retirement
As a believer of not killing the golden goose, my strategy of only spending the dividends has a downside – it requires a large portfolio. For example, going for $40k in dividend income, assuming 4% yield, would require a $1M portfolio; $60k in dividend income requires a $1.5M portfolio; and $100k in dividend income would require a $2.5M portfolio.
While a multi-million dollar portfolio may seem out of reach for some, you likely won’t need that much capital for a comfortable retirement. Especially if you are getting close to retirement age! Choosing a regular retirement in the 60-65 age range puts much less strain on your personal finances. Why? Because of government senior programs. The average senior benefits payout for a couple (age 65) that has lived and worked in Canada all of their lives is about $30,000. That’s $30,000 before dipping into any of your investment accounts like your RRSP, TFSA etc.
If you spend your money efficiently like the family above and average $50k in spending a year, that would leave you with a $20k income gap. This could be made up with income sources such as a defined benefit pension, building your own pension with an annuity (approx $330k for a $20k/year benefit), part-time work, and your investment accounts. If depending on your investment accounts, you would require approximately $500k to generate $20k/year for 30 years based on the 4% rule.
If you are young and interested in personal finance and investing, FIRE is achievable with some strategy and focus. If that is your goal, then a good measuring stick is to chart out and follow your crossover point. The more aggressive your savings and the lower you keep your annual expenses, the faster you will achieve FIRE. For example, if you can save 50% of your take-home pay, you will reach FI in about 16 years. If can bump that savings rate up to 65% (pretty extreme if you ask me), then 10 years should do the trick. See this article for more detail.
On another note, if you dream about early retirement because you dislike your current job, then I think that refocusing your career into something that you may enjoy is a better strategy – even if it pays less! After all, even if you reach FI, retiring “to” something is the real goal rather than retiring “from” something you didn’t enjoy.