Fifteen Years to Financial Independence

There are many aspects of life that seem to follow a general pattern:  What we know is good for us in the long run seems contrary to what we think is pleasant or pleasurable in the short run.  This is obviously one of the main reasons that people make poor choices regarding food and smoking on a day-to-day basis even though everyone knows, at an intellectual level, that those poor choices will eventually come back to haunt us.  Of course, the same issue exists when it comes to personal finances.  Almost everyone understands the importance of savings, but our consumer culture bombards us with constant prompts to spend in an elusive quest for immediate gratification.

How is it possible that inflation adjusted per-capita gross domestic product (GDP) in the United States has nearly quadrupled over the past seventy years, yet many people continue to struggle with budgeting to the point where accumulating meaningful savings appears to be an insurmountable task?  Take a look at the chart below from the Federal Reserve’s FRED website:

It might be hard to believe, but Americans in the halcyon days of the 1950s were somehow happy living on per-capita incomes in the $16,000 range.  To be sure, this is a per-capita number and there were large percentages of the population that were far poorer, particularly minorities suffering from institutionalized discrimination.  Nevertheless, the meaning of what it meant to be “middle class” in the 1950s and 1960s would surely be considered to be “poor” in today’s terms.

Consider the typical 70 year old individual who has lived through this remarkable period of economic progress and, assume further, that this hypothetical individual has been right at the per-capita average in terms of personal income.  The gains probably appeared to be very gradual over his lifetime, with some bumps along the way.  Most likely, he has ratcheted his lifestyle upward slowly over time, perhaps without even realizing it, so the gains never seemed that dramatic.  In contrast, let’s say that this individual had an experience similar to Rip Van Winkle and magically fell asleep in 1997 and woke up yesterday.  The 30 percent gain in per-capita GDP would likely feel much more noticeable because it was experienced all at once rather than diffused over twenty years.  We are conditioned to slow changes in our environment, and these changes blend into the background.

The Virtuous Cycle

Perhaps the most important hurdle to financial independence involves a complete rejection of the ratcheting lifestyle trap and conscious awareness of the enormous abundance of goods and services we enjoy in the United States today compared to previous generations.  There is no doubt that disparities continue to exist but, in aggregate, the United States has never been richer than it is today and per-capita incomes have never been higher than today.  Why, then, are we made to feel like we are deprived of something if we choose to refrain from continuously ratcheting our lifestyle in lockstep with real GDP?

The virtuous cycle of financial independence is simple to understand:  Consumption and savings are two sides of the same coin.  What we do not consume can be saved and invested.  The less we are accustomed to consuming, the easier it will be to accumulate enough assets to generate passive income sufficient to fund all of our consumption.  The flip side is also easy to understand.  If we consume nearly all of our income, our savings will be meager in absolute terms and will never accumulate to the point where it is sufficient to generate passive income to meet our much higher consumption requirements.

At the risk of being slightly repetitive, the benefit of a high savings rate is not only the fact that money is accumulating at a faster rate, aided by the power of compound interest.  In addition, we make it far easier to reach the day where we reach “escape velocity” and our savings produce passive income sufficient to make working for others truly optional.  And there is massive value in having that financial freedom even if one wishes to continue working for others.

The Young Married Couple

It is far, far easier to adopt a Spartan mindset early in life rather than attempting to ratchet back a lifestyle that already consumes the vast majority of your income.  The hedonic treadmill concept of psychology makes it clear that we quickly adapt to higher levels of consumption which becomes considered the “baseline”.  But the effect is not symmetrical when we cut consumption below that new baseline.  To be sure, a rationalization of spending and a reduction to lower levels can be done and has been done by many people, but it is far better to adopt the Spartan lifestyle at an early age.

Let’s assume that we are looking at the situation facing a young married couple who met in college, found meaningful employment after graduation, had two children, and are now 25 years old.  They were industrious and frugal for their first couple of years in the workforce and managed to pay off their student debt, which was modest because they attended in-state public universities and also had a little bit of help from family.  As a result of this frugality, they retained the “college lifestyle” and are still accustomed to living on a small amount of money every month (around $2,000).  The first couple of years in the workforce were successful, they had a couple of children, and they do not plan to have any more.

A good education and industrious habits have resulted in pre-tax income of $100,000 for this two income couple.  They are ready to start enjoying more of the fruits of their labor but have had a lifelong goal of achieving financial independence by middle age, not because they necessarily want to “retire”, but because they want to have the option to fully control their time.  How realistic is this goal?

Financial Freedom by Age 40

The couple is well positioned to reach their goal due to their $100,000 pre-tax income and the fact that they have diligently kept their monthly spending to around $2,000 per month.  Understandably, a couple earning $100,000 would wish to enjoy some of that income as they go through their lives rather than saving everything, but the extent to which they choose to increase spending will have a major impact on achieving their goals.

Let’s assume for the sake of simplicity that the family lives in a state with no income tax such as Texas or Florida.  Due to their married status and the benefits associated with having two children, the federal tax burden is relatively modest at around $9,400 using 2016 tax rates (CalcXML’s tax estimator was used to derive this figure).  In addition, the couple will owe Social Security and Medicare taxes of $7,650, or 7.65 percent of their gross income.  The total income tax burden is about $17,000, leaving the family with $83,000 of after-tax income to allocate.

Let’s say that the couple decides to increase monthly spending by 50 percent to $3,000 per month.  That’s a significant increase in monthly spending and should have a noticeable impact on their day-to-day lives.  This implies a savings rate of about 55 percent of their $83,000 after-tax income.  Actually, that savings rate results in $37,350 available for spending so the family can take a modest vacation in addition to spending $3,000 per month ($36,000/year) on other expenses. They have no savings to speak of today, so they are starting from scratch.

Can this really be done? 

From the standpoint of someone earning and consuming $83,000, moving to a 55 percent savings rate will seem agonizing.  But it will not be agonizing at all to this family because they are increasing their spending by 50 percent!  For them, it is a windfall and will seem luxurious in comparison to their prior lifestyle.

To be sure, spending $3,000 per month isn’t going to result in luxury living but it can go further than many people assume through intelligent and thoughtful spending. However, the upside is that this plan is very likely to result in financial independence for the couple by the time they are 40 years old.  Ultimately, it is a matter of priorities.  There will no doubt be peer pressure from coworkers and, possibly, family members to consume more given the family’s income.  That’s where self control comes into play.

A Look at the Data

Let’s get down to the specifics of this situation.  Here are the assumptions:

  • The couple earns $100,000 pre-tax and retains $83,000 after tax.
  • The 55 percent savings rate results in annual spending of $37,350 in the first year.
  • The family achieves a 1 percent real increase in income annually.  In other words, if inflation is 2 percent, the assumption is that the family’s nominal income will rise by 3 percent.  The savings rate stays constant over time, meaning that the family increases both real spending and real savings by 1 percent annually.
  • The real return on investment is assumed to approximate 5 percent.  The Standard & Poor’s 500 stock index has generated real returns of approximately 5.4 percent over the past twenty years according to an investment calculator that uses data provided by Robert Shiller.
  • Assume a withdrawal rate of 3.5 percent of savings.  Once the family reaches a savings level where a 3.5 percent withdrawal exceeds annual spending, we consider them to be financially independent.

It is important to emphasize that the figures that appear in the table below are adjusted for inflation and represent real purchasing power using 2017 dollars.  Also, note that the family is not totally deprived of increases in their standard of living which we allow to rise by 1 percent annually.

The table shows the starting balance of the family’s savings (which is initially zero), the annual investment assumed to be made in a lump sum at the end of the year, and the ending balance of savings assuming the additional investment along with the 5 percent return.  Obviously, in reality, the return will not be a smooth 5 percent but will vary along with the gyrations of the stock market.  The final two columns show the family’s annual spending along with the potential withdrawal rate based on the year-end savings balance.  The green rows show years when the potential withdrawal exceeds the family’s annual spending – that’s the point at which financial independence has been achieved.

Is it surprising that the family can achieve millionaire status (in real, inflation adjusted dollars) in just fourteen years and be financially independent in fifteen years?  Not really, because the power of saving 55 percent of after-tax income coupled with compounding of returns has combined to turbo charge the size of the portfolio.  We can see this effect accelerate further after year fifteen, should the family choose to continue working rather than retire.  Within 30 years, the family will have savings of over $3.6 million.  Even more importantly, that level of savings would allow for annual spending of nearly $127,000, far in excess of what the family is accustomed to.

The Other Path

This is a hypothetical example and the lives of real people including those reading this article will invariably be less perfect and more complex.  However, the basic principle remains valid.  The path to financial independence involves harnessing the virtuous cycle of limiting consumption and saving an unusually high percentage of income.  Doing this will almost inevitably result in financial independence due to the power of compounding over long periods of time.

But let’s briefly consider the more typical scenario where the family has taken the advice of financial planning “experts” and saved only 10 percent of after-tax income.  Ten percent is considered a “high” rate of savings, and it is compared to the majority of people, but it is totally insufficient to result in savings that will ever replace the family’s much higher level of consumption.  Leaving all other assumptions unchanged but changing the savings rate from 55 percent to 10 percent yields the following scenario:

The family is consuming nearly $75,000 per year and saving a paltry $8,300.  After 30 years, the savings balance is just over $650,000 which would support annual withdrawals of $23,000, but by that time the family is accustomed to spending over $100,000 per year.

At the age of 55, the couple is not financially independent, and not by a long shot.  They can both choose to continue the status quo and work another ten years.  At that point, they would finally reach millionaire status with savings of $1.2 million which could generate close to $43,000 in annual withdrawals, but by then they are accustomed to spending over $111,000 per year.  So, at the age of 65, the couple will have to make some tough choices.  They can cut their consumption and start taking Social Security and should be able to retire.  However, cutting consumption will not be any fun, having been accustomed to higher spending for decades, and they will have little margin for error should unexpected expenses come up.

Conclusion

The pursuit of financial freedom is not for everyone.  Many people will never do it because they will allow a ratcheting lifestyle to absorb all available resources.  Or, as in the “other path” scenario above, they might follow the advice of a “financial expert” and save 10 percent of income and be able to retire by age 65, but not without making compromises after a lifetime of being accustomed to much higher spending.  In contrast, thoughtful choices early in life can yield an alternate outcome – financial freedom in early middle age that allows for many additional choices later in life.

Some will inevitably object to the entire premise by claiming that the scenarios completely ignore the utility the couple would get from a higher level of spending over 30 or 40  years compared to the more restrained spending that would allow for early financial freedom.  This isn’t entirely invalid since additional spending should lead to increased utility, but beyond a certain level that spending isn’t correlated with a higher level of happiness.  Instead, the hedonic treadmill takes over.  We become accustomed to the higher level of spending and will notice it when it is gone, but will not get much out of in on an ongoing basis.

Ultimately, the choice is yours to make.  And the choice isn’t restricted to a couple that is just starting out either.  Someone who is 40 years old could employ the exact same approach to reach financial independence by age 55.  The difficulty is that a 40 year old would likely have to adjust spending downward in order to implement the strategy, but “difficult” isn’t synonymous with “impossible”.  The tangible and intangible benefits of financial freedom cannot be reasonably attained without making at least a few sacrifices.

Readers can download the spreadsheet used to develop the scenarios above and play around with the assumptions.

Disclaimer:  This article is not financial advice.  Seek the advice of a financial professional if necessary. 

Everything is Negotiable – Including Your Cable Bill

In a cash-based economy, people tend to negotiate when it comes to all sorts of purchases as they go through their daily routines.  Part of this is obviously due to culture and a history of bartering, but it seems like that the need to part with actual physical currency might play a psychological role as well.  If you are paid in physical currency for your labor, that represents tangible evidence of your effort and parting with currency demands receiving value – for every single transaction.  Our modern system of relying on electronic payments for an increasing share of our day-to-day spending and almost all of our large recurring expenses tends to dull the linkage between earning money and spending it.

Of course, whether we make a payment in cash or use a credit card or other form of electronic payment makes no difference when it comes to our long term purchasing power.  We are still ultimately constrained in our consumption based on the financial resources we have access to and we still need to focus on obtaining value for each and every purchase.  For a surprising number of transactions, we should avoid the tendency to believe that pricing is “fixed” and look for ways to save money through negotiation.  Furthermore, it is actually relatively easy to negotiate with large businesses which might seem a little counterintuitive.

Cutting a Deal with Comcast

There are very few companies that are as infuriating to deal with as providers of cable television, internet, and phone services.  Most people have only a couple of viable choices and the service is viewed as non-discretionary.  My personal opinion is that television and landline service is completely discretionary but having access to reliable high speed internet is mandatory.  I view high speed internet as being on par with having electricity and water in my home.  I do not own a television and do not have a landline.  This “cord cutting” is possible, in large part, due to the ability to have fast and reliable internet connectivity on demand.

Over the past several years, I have routinely switched between Comcast’s Xfinity and Verizon’s Fios services.  It has been possible to obtain reasonably high speed internet service for under $50 by subscribing to introductory plans, usually with a one year discounted period.  After that one year, the price of service usually goes up dramatically and I simply switch back to the other carrier.  However, these companies do not make it easy to switch.  You cannot cancel online and have to endure long wait times and amateurish sales pitches intended to retain your business.  It can take an hour or more to make the switch each year.

In February 2016, I switched to Comcast at a rate of $34.99 for their “Performance Internet” package which normally cost around $60 based on my recollection of pricing at the time.  This plan recently expired and Comcast tried to charge me $74.95 for next month’s service which is far more than the $60 that prevailed last year and, in my opinion, a ridiculous amount to pay for internet service.  I looked into switching to Fios but there were no good discounted plans available in my area.  As a result, I logged into the Comcast site to examine my options.

Bundles and Price Transparency

The first thing I noticed was that Comcast tries to direct people toward their Triple Play package which includes internet, television, and a land line.  There’s an absolutely dizzying array of choices and the first three (of many more) are shown below (the prices are regional so they might differ in your area):

One of the key features of Comcast’s pricing is that they make it as confusing as possible to compare apples to apples. You have all kinds of variables shifting around, such as the number of channels, the speed of the internet service, and various extras that are included.  The names of the plans are confusing and make it nearly impossible to compare the value between plans.  There is also different pricing for agreeing to a two year contract versus having no term agreement.

The confusion is intentional, as is the attempt to direct people to bundled packages where they cannot clearly see how much they are paying for each distinct service.  I have no desire to have television or land line service, so I hunted around the site to find the current pricing on internet-only plans:

I use the internet for my work which requires the ability to easily download documents and to manage various activities that are cloud based, but I rarely watch videos or stream other content.  As a result, I decided that I would just switch to the “Performance Starter” plan for $49.95 per month.  It is more than the $34.95 I am currently paying but since Fios doesn’t seem to have cheaper options, I thought it made the most sense to just switch to the $49.95 plan.  Of course, I couldn’t do this easily on the website so I had to call customer service.

No WiFi?  Are you kidding me? This is 2017! 

After about 20 minute going through endless automated menus, I finally reached a representative who tried to talk me into keeping the $74.95 plan.  Finally, she agreed to switch me to the $49.95 plan, but there was a catch:  That plan only allows customers to connect one device at a time.  And there’s more:  You have to use an Ethernet cable to connect that device!

That’s right:  Comcast’s entry level internet plan does not allow customers to connect a WiFi router and use devices like smart phones, tablets, or modern laptops.  They want you to use a wired connection.

Why?

It has nothing to do with bandwidth.  Comcast is providing a certain level of bandwidth and it doesn’t cost them any more to allow customers to use WiFi.  The reason is to make the plan unattractive and unusable, thereby pushing customers toward more expensive options.

Now, at this point, most people would probably resign themselves to just paying the $74.95 per month, ending the endless phone call, and getting on with their lives.  But I was angry because I knew what Comcast was trying to do.  They force customers to endure a long, frustrating phone call.  They attempt to use text book sales tactics to get customers to buy more than what they want.  And then they finally “agree” to switch me to the plan I wanted, but then tell me that it is essentially unusable. So, I was quite angry by this point.

I threatened to simply cancel service.

This wasn’t really a bluff  because I could have switched to Fios for around $60 per month.  It would have still been cheaper than the $75 Comcast was asking for, although it would have been a hassle.

So, what happened?  I was transferred to a “customer retention” representative who immediately offered to discount the $74.95 plan to $59.95 for another year.  I immediately said no.  I was then put on hold for another five minutes.  The representative came back and said that he was sorry but that was the best Comcast could do.  I again told him to cancel my service.  After another hold, he came back and offered $49.95 which I agreed to.

Almost Everything is Negotiable

Big companies like Comcast that operate in industries where customers have few choices thrive on making their pricing as confusing as possible, offering decent deals for a limited period of time, and then hoping that customers simply continue to pay the higher price due to inertia and the fact that automated billing makes it easy to do nothing.  However, the marginal cost of providing internet service to an existing customer is low and retention of customers is very important.  These companies do not want to lose your business.  They make it difficult and frustrating to cancel but, if pushed, will often provide much better deals than advertised on the website.

It is true that I spent about an hour in a state of extreme frustration with the entire process, but the result was saving $300 over the next year compared to the “auto-pilot” option of doing nothing.  $300 is a significant amount of money, and compound interest will make it even more significant when saved or invested for the future.  My time is valuable, but I’m still willing to trade an hour to save $300, and I think almost all readers probably would feel the same way.

The way Comcast and similar companies treat customers is infuriating but they are selling internet services that, in my view, are not discretionary.  We have much more competition in wireless phone and internet service than we do for home internet service and companies like Republic Wireless make it extremely simple and transparent to purchase service for a very reasonable cost.  It would be great if we could have cheap, wireless service intended for more intensive home use.  Until that happens, it is necessary to negotiate.  It is unfortunate that few people even realize that companies like Comcast will move on pricing when they are pushed to do so.

Teach Compound Interest in High School Math Courses

According to a recent report, 66 million Americans have absolutely no savings available to cover a financial emergency.  This shocking figure is nearly one-third of the roughly 206 million Americans between the ages of 15 and 64 which makes up the age group most likely to lack a safety net to deal with emergencies.  A recent survey by Standard & Poor’s revealed that only 57 percent of Americans are financially literate.  Although it isn’t a good idea to unfairly stereotype individuals in large groups, it seems very likely that the Americans lacking savings also have a general lack of understanding of basic personal finance.

Why is this the case and what can be done about it?

One of the problems is that human beings do not seem to naturally understand non-linear systems, and this deficiency prevents us from automatically understanding what is perhaps the most important topic in personal finance:  compound interest.

Here is one of the questions asked in the financial literacy survey:

Suppose you had $100 in a savings account and the bank adds 10% per year to the account. How much money would you have in the account after five years if you did not remove any money from the account: more than $150, exactly $150 or less than $150?

It is likely that most people would understand that 10 percent of $100 is $10 which represents the first year of interest.  The account will be open for five years, so many people will be tempted to simply multiply the $10 by 5 and come up with $50 in total interest which is added to the initial $100 balance for a total of $150.  However, this ignores the fact that you earn interest on interest which is the essence of compounding.  Assuming annual compounding, the balance of the account would look like this over the five year span:

A simple formula can be used to determine the ending result of a sum invested at a certain rate over a certain period of time:

Ending Balance = Starting Balance * (1 + Periodic Interest Rate) ^ Number of Periods

The formula can be applied to this example as follows:

$161.05 = $100 * (1 + 0.1) ^ 5

Compound interest is an example of an exponential equation and the results do not neatly fit our natural intuitions.  It is much more intuitive to think that the $100 deposit will earn $50 over five years than to figure out the actual result which is significantly more than $50.  However, it is important to realize that this particular exponential function is very simple and should be understandable to the vast majority of people if explained clearly as part of a basic education.

Extending the Deposit to 50 Years

To make the effect of compound interest more clear, let’s extend the period of time that the $100 is kept on deposit at a rate of 10%.  Rather than assuming five years, let’s assume that the money is left alone for fifty years instead.  If we apply the same “gut instinct” (but incorrect) logic that would have led someone to believe that the $100 deposit would only earn $50 over five years to this longer example, the answer would be that the fifty year deposit should earn a total of $500, which is 50 years multiplied by $10 per year.

Let’s see what the correct result is:

Ending Balance = Starting Balance * (1 + Periodic Interest Rate) ^ Number of Periods

This formula can be applied to this example as follows:

$11,739.09= $100 * (1 + 0.1) ^ 50

Instead of earning the $500 that “gut instinct” might have led us to believe, the $100 deposit earns a shocking $11,639.09 in interest!

This unintuitive result is due to the exponential nature of compound interest, as we can see from the graph below:

We can see that progress is slow at first, which we already knew based on the first five years of the investment.  However, over time, earning interest on interest becomes the driving force behind the overall value of the account and we can really see the line start to explode upward over the second twenty-five year period.

What Applies to Savings Also Applies to Debt

How many people truly understand the horrible compounding effects of credit card debt?  Although paying 15 to 20 percent interest on a $1,000 sofa might seem like an annoyance over the first year, making minimum monthly payments while taking on additional debt will cause the problem to snowball over time in just the same way that savings multiplied like crazy in the previous example.  Actually, the snowball will be much worse. Compounding at 15 to 20 percent results in a much, much larger snowball than compounding at 10 percent.

Although credit card disclosure requirements have improved over the past several years and people are now clearly told how long it will take to retire debt based on minimum monthly payments, few people are going to pay much attention to the details on a credit card statement or stop using the credit card while paying it down.

Low Interest Rates Make Compounding Less Obvious

The example in the survey uses a rate of 10 percent for a savings account which is obviously unrealistic in today’s world of minuscule savings rates.  However, low interest rates are probably not going to be a permanent phenomenon over the long run.  The problem is that people have been trained to not appreciate the power of compound interest over the past several years because it is even less apparent than it otherwise would be.

Using a rate of 1 percent, which one would have been fortunate to get on a savings account over the past five years, the $100 deposit would have grown to only $105.10 over five years.  In this case, the “intuitive” answer of believing that the total interest would be only $5 is hardly different from the correct answer of $5.10.  In fact, it is so trivial that if we used the 1 percent rate in an example, people would laugh if we tried to claim that compound interest is actually important.

Multi-Disciplinary Education

Financial education is severely lacking in the United States and the fact that over half of Americans lack basic financial literacy is a national disgrace.  The place to remedy the problem has to be the public school system.  Ideally, parents would educate their children on personal finance but too many adults are financially illiterate and we do not want to have a society where this perpetuates through multiple generations.

It should not be difficult to incorporate an appreciation for compound interest into the public school system.  Basic exponential functions are routinely taught at the middle school level and, if not, certainly as part of a high school curriculum.  Rather than using esoteric examples that students might not relate to, teachers could incorporate compound interest directly into basic math education covering exponential functions.

But is it the job of math teachers to cover personal finance?  The better question is why not?

There need not be a special course in personal finance (although such an offering has obvious merits as well).  Disciplines like mathematics should incorporate subject matter from other disciplines, particularly when doing so reinforces the math that is being taught.  All young people are concerned with having enough money to spend.  They might be too impulsive to care about long term growth of savings, but if they are at least aware of the potential of compound interest, that might prevent the accumulation of unwise debt in college or when starting out in the workforce.

Parents who are fully aware of the power of compound interest might try bypassing today’s low interest rate environment by setting up a family “bank” where their children can make “deposits” at rates that are far above market and possibly compound at a more frequent pace.  For example, parents could offer their children an “account” that compounds at a rate of 5 percent every quarter.  At that rate, a $100 deposit would grow to almost $150 over two years, well within the time frame that a teenager should appreciate.

Not a Panacea, But a Start

Even if every American left high school with a solid understanding of compound interest, we will still have people who fail to save because they lack self control or fall into really hard times through no fault of their own.  However, it is hard to believe that wide dissemination of this very basic principle would not dramatically reduce human misery.  Not being able to cover the cost of a broken refrigerator, a tire blow-out, or a traffic ticket should be preventable for almost everyone.

There are enough truly difficult problems in life that do not lend themselves to simple solutions, so we should adopt simple ideas that have little or no downside such as teaching students about compound interest as part of their existing math programs.  It might be wishful thinking to hope that all Americans will automatically think in terms of exponential functions rather than using their linear intuitions in everyday life.  But when faced with major life decisions, the default should be to think in terms of compound interest when it comes to spending and saving money.

Escaping the Ratcheting Lifestyle Trap

The Wall Street Journal published an interesting article recently regarding the sad financial future awaiting many NFL players.  The article cites a study that analyzed the financial data of more than 2,000 players who were drafted by the NFL from 1996 to 2003.  These players were followed until 2013 to see how their financial health would hold up after retirement.  After 12 years in retirement, more than 15 percent of the players who were followed had declared bankruptcy.  Were these players predominantly those who were drafted and only played a year or two at the lower end of the pay scale?  Apparently not.  Earning a higher income or having a longer playing career did not seem to offer much protection against bankruptcy after a player’s NFL career came to an end.

There is no shortage of statistics when it comes to professional sports, and this is as true for salary information as it is for measures of athletic performance.  The Spotrac website offers a wealth of information on current NFL salaries, including a ranked list of the top 1,000 cash salaries in the league.  In 2016, the top earning player was Drew Brees at $31.25 million.  Nearly 100 players earned over $10 million in cash compensation while 880 earned over $1 million. In 2015, the average NFL salary was $2.1 million while the median salary was $860,000.  The rookie minimum wage was $435,000.  1,696 players were employed by NFL teams.

So these guys are making very, very good money at a very young age and it is safe to assume that the vast majority of these players in their early 20s have never seen this kind of money before.  Here’s the problem:  The average length of an NFL career is only 3.3 years, although this figure varies widely based on the position played and the ranking of the player in the draft.  But how many new guys entering the NFL believe that their career will be just a few years?  Probably very few.  They see the money coming in, feel invincible, and believe that the good times will keep rolling indefinitely, or at least until their 30s, which for someone who is 22 seems a lifetime away.  How do you think they are going to choose to spend their newfound wealth?

Beware of the Ratcheting Lifestyle

The financial problems facing new NFL players are different than what most of us face in life, but only because the abrupt change of income experienced by players is far more noticeable than what the rest of us experience.  An NFL player goes from earning little or nothing to earning at least $435,000 per year as a rookie, and subsequently will earn much more if he performs well and remains healthy.  The rest of us earn little or nothing while in high school or college and then experience a significant jump in pay, but obviously nowhere near a half million dollars.  Then, if  all goes well, pay will rise gradually over time as we get more experience and take on more responsibility.

In some ways, the NFL player should have an easier time avoiding the temptation to ratchet his lifestyle significantly because it is obvious that playing careers do not last very long.  If it is very unlikely that a player will be in the NFL past age 30, it is obvious that plans need to be put in place to address that, whether it involves a second career or accumulating enough assets to be financially independent.  The rest of us do not have these obvious prompts to consider our level of spending.  Most people immediately ratchet up their lifestyle after graduating from college and save very little.  Then, annual raises are automatically spent as they are earned.

The Hedonic Treadmill

But wait a minute … what is wrong with increasing spending as one’s income increases?  Isn’t one of the major motivations for going out and getting an education (or making the NFL) the idea that we can then life a more comfortable lifestyle?  This is certainly true for most people and studies have shown that people do gain a significant amount of happiness as they increase consumption to meet basic needs.  Many people will experience happiness beyond that point as well, although obviously the degree to which happiness is correlated with increased consumption will vary based on personality and other factors.

However, one aspect of human nature that seems universal is that at some point, the degree of happiness one gets from spending an additional dollar declines.  Furthermore, human beings have a tendency to return to a stable level of happiness after a major life change.  This is referred to in psychology as the hedonic treadmill effect.  (As an aside, one of my favorite books on psychology, Thinking Fast and Slowby Daniel Kahneman touches on this subject along with many others.)

The temptation facing the NFL player is probably quite extreme.  Going from earning no money to earning, perhaps, half a million dollars in his first year, it would be difficult to avoid peer pressure to go out and buy a luxury car, a new home, better clothing, and to spend lavishly on entertainment for real and fake friends, as well as to try to help out family members.  Getting into the NFL is a very high publicity event.  Everyone the player has known for his whole life will probably become a new “friend” instantly and given that the player is now “rich”, he might seek to impress his new “friends” with money.

A new college graduate who is entering a more prosaic field, such as accounting, faces some of the same psychological impulses, although at a less extreme level.  With a new job paying $50,000 per year, she might move into a recently built apartment in the city, spend more on personal services, go out to eat and drink with friends, purchase new clothes, and make a down payment on a more modest car.  But she is facing similar temptations to spend up to her newly found income limit.  And in some ways, her problem is worse than the NFL player’s because there is no real upper bound on how long an accountant can work.  You can have a 50 year career in accounting, assuming that you want to have one and jobs are available.  So why not go out with friends and drink $15 cocktails?

So, We Should Save Everything? 

The point isn’t to suggest that people who have suddenly experienced an increase in income should take no actions whatsoever to fund a better lifestyle.  It would be ridiculous to suggest that an NFL player, or our accountant for that matter, should be subjected to poverty and save almost everything.  That isn’t the point.  The goal is to be mindful regarding spending and to understand the trade-offs that inherently exist.  Also, it is important to know yourself and how your personality will deal with the diminishing returns from additional spending.  You don’t want to be a hamster on the hedonic treadmill.

The question of how quickly to increase spending when income suddenly increases depends on many factors, some of which include:

  • How long will the increase in income last?
  • What is the starting level of spending that you are accustomed to?
  • How much do you enjoy the work involved in earning the income?
  • How likely is it that employment in your chosen field will continue to exist in the future?
  • How important is financial independence to you, irrespective of whether you like your work?

For the NFL player, it is pretty obvious that the income will not last for very long no matter how much the player enjoys playing football.  So a good question to ask is whether the player wants to work in some other field after his playing career is over.  The stereotype of the academically challenged jock is just that, a stereotype, and there is no reason why a former NFL player in his late 20s or 30s cannot have a full career in some other field.  Even if so, financial independence after the NFL, or at least some assured minimum level of income for life, seems to be a worthy goal.

Financial Independence After the NFL

Assume that a player is drafted and earns a first year salary of $500,000 followed by an increase to $750,000 in the second year, and $1 million in the third and fourth year.  On the final game of the fourth season, the player suffers a career ending injury and has to retire.  In aggregate, the player will have earned $3.25 million in gross pay over four years.  For purposes of this brief analysis, assume that the player lives in Texas and does not incur state income taxes (although this is unlikely since many states will tax players on games played in-state).

H&R Block provides a free tax estimator that I will use for this example.  Assuming that the player is single with no dependents and takes the standard deduction, he will earn the following on an after tax basis:

  • Year 1:  $500,000 gross income – $154,375 tax = $345,625 net income.
  • Year 2:  $750,000 gross income – $255,625 tax = $494,375 net income.
  • Year 3 and 4:  $1 million gross income – $356,875 tax = $643,125 net income.

We can see that the $3.25 million in gross pay has already shrunk to a little over $2.1 million after paying federal income taxes.  How much should the player spend and save each year?

Here, the situation becomes even more interesting.  First of all, the player does not know that he will be forced to retire after four years.  He only finds out at the end of the fourth season when he suffers a career ending injury.  Therefore, from the perspective of the player at the start of his career, it is not apparent that his lifetime earnings from the NFL will be around $2.1 million in terms of cash in his pocket.

But for the sake of argument, assume that the player knows that the average NFL career is under four years and intelligently assumes that he won’t beat the average by that much.  Also, assume that he can predict his salary increases after his first year.  So, now we have a 21 year old newly minted NFL player with almost $350,000 of income in year one.  How much should be spend and save?

To answer this question, let’s assume that the player wants to ensure that he has at least some minimum level of financial security after retirement from the NFL, for life.  Median household income in the United States in 2015 was slightly over $56,000.  Let’s say that we define financial security as the ability to withdraw $56,000 from a portfolio on an inflation adjusted basis in perpetuity.  Using the 3 percent withdrawal rule that I prefer, the portfolio needs to be 33 times the withdrawal level, or 33 x $56,000 = $1.85 million.

$1.85 million!  On an after tax basis, our NFL player is only collecting $2.1 million in cash over his four year playing career!  Ignoring investment returns, this means that the player only really has about $250,000 to spend over his four year career in the NFL, or approximately $62,500 per year, on average.  In reality, the situation is probably a little bit better because he will be earning investment returns on funds saved during the course of his playing years, so let’s say that he can spend about $70,000 per year while playing.  If he spends $70,000 per year during his playing career, it seems likely that he will have a large enough investment portfolio to be financially secure for life, if we define financial security as the ability to withdraw, on an inflation adjusted basis, the median U.S. household income in perpetuity.

Is This Realistic? 

The honest answer is probably not, at  least for the average NFL player.  There are very, very few men in their early 20s who are going to have the self discipline to earn enormous salaries in the NFL but spend only $70,000 per year on an after tax basis.

Yet is clearly possible.

Plenty of people get by on far less than that.  Furthermore, $70,000 is well above the typical gross income in the NFL player’s age cohort.  In other words, his friends from high school and college who are not playing in the NFL but working in other jobs are likely to earn far less.  So, we are not talking about any major deprivation here, only exercising a very unusual level of self restraint.

What does seem to make a great deal of sense is for an NFL player to be very, very conservative in his early years while stockpiling an initial sum that can guarantee financial independence for life.  After that point, if he is still playing, it is very likely that he will be earning a much higher salary.  Staying in the NFL for a decade or longer is not just a matter of staying healthy.  You have to perform.  Veteran players in their late 20s and 30s are going to earn several million dollars per year.  Younger players should attempt to defer big ticket items until later in their career once basic financial freedom has been assured.

But What’s the Alternative?

Taking a more common path, the player will probably spend the vast majority of the $350,000 in cash received during the first year.  Spending on a luxury car, better clothing, vacations, and entertainment can easily soak up a couple hundred thousand dollars, and perhaps he will also make a down payment on a house.  With an increase in income in the second year, spending will ratchet accordingly and probably include even more entertainment, perhaps a second car, and much else.  After reaching a salary of $1 million in year three, all sorts of additional spending options come into play, perhaps even including a small share of a private plane.  After all, many veteran players are earning $10 million per year, so why not?

The tragic consequences of a career ending injury at the end of year four becomes glaringly obvious for someone who has adopted that kind of lifestyle.  Not only are his playing days over, with the associated loss of prestige and popularity, but there is suddenly much less income, even if there is some element of insurance that comes into play.  And the lifestyle that he has become accustomed to is suddenly out of reach.  With no plan for a second career, it’s easy to see how the player will have little or no net worth along with high fixed expenses.  It isn’t surprising that 15 percent or more will eventually suffer bankruptcy.

There are lessons for the rest of us here as well.  We should all strive to understand the hedonic treadmill and the fact that we are not going to make ourselves happier on a sustained basis merely by increasing our spending.  We should be aware of the risk of making choices that do not increase happiness but do reduce financial flexibility in the future (such as purchasing an expensive car on credit, living in a large home in a suburb 30 miles from work, etc).  If we consider financial freedom at a relatively young age to be intrinsically valuable regardless of whether we wish to continue working, then some thought needs to be given to having restraint in the early years, and that is especially well illustrated by the choices facing a new NFL player.

When Can You Consider Yourself Financially Independent?

When can you give up the security of a regular paycheck?

This is a fundamental question that everyone must eventually answer in the context of their own “retirement”.  I put “retirement” in quotes because what we are really talking about here is not necessarily retirement in the conventional sense of the word but rather attaining the level of financial independence that is needed to make a regular paycheck optional.  You might like your job and have great relations with your boss today, but that could always change tomorrow or next month.  A recession could result in layoffs and you might find yourself involuntarily out of work.  Illness has been the cause of many premature exists from the workforce.  At what point are you immune from having to worry about drawing a paycheck to fund your lifestyle?

The following Dilbert cartoon humorously illustrates what I am referring to:

Nassim Nicholas Taleb should properly be credited with the concept of “F*** You Money” that he developed in The Black Swan and has elaborated on numerous times since the book was published, such as in this Facebook post from 2015.  Now, not everyone works for a pointy-headed boss and hates their job as much as Dilbert and Wally, and plenty of people actually love their job and enjoy the people they work with.  Whether or not you like the kind of language used by Scott Adams or Nassim Taleb, the point is obvious:  When can you declare independence from paid employment if you choose to do so?

At the risk of stating the obvious, there are two major factors that we need to look at:

  1. How much money is needed to fund your lifestyle every year?  The answer is not as simple as looking at what you are currently spending every year.  There will probably be expenses related to work that will entirely disappear from your budget if you choose to leave paid employment.  You will no longer have to commute to work so the cost of driving or public transit will disappear.  Maybe you can even give up your car entirely.  It will be unnecessary to purchase clothing specifically for work (I can count the number of times I’ve worn a tie over the past eight years on two hands).  If you aren’t packing a lunch for work almost every day, you are probably spending a lot of money on eating out and that could be eliminated as well.  This list isn’t exhaustive.  On the other side of the equation, you will incur new expenses in “retirement” such as the cost of health insurance, which is probably going to be the largest new big ticket item.  Also, you will have more time to travel and pursue recreational activities.  You could very well end up spending more money in “retirement”!
  2. How much money have you saved?  This is obviously simpler to answer but, unlike many personal finance articles, I don’t think that it can be distilled to a single number.  Most importantly, it is critical to differentiate between assets that are accessible and assets that are locked up for an extended period of time.  If you are 40 years old and contemplating giving up your paycheck, what matters for the foreseeable future is the amount of liquid assets that you have in non-retirement accounts.  You do not, I repeat do not, want to even contemplate touching retirement funds in a 401(k) or IRA because early withdrawal penalties are significant for anyone who is younger than 59 1/2 years of age.  You also do not want to consider any form of home equity unless you are planning to downsize to a smaller home in retirement.

If you read enough personal finance articles, you probably have already come across discussions of “safe withdrawal levels”.  The idea of a safe withdrawal level is to calculate the amount of money that can be withdrawn from an investment portfolio on an inflation adjusted basis over a specific period of time without running a significant risk of depleting all of your assets.  There are usually a number of embedded assumptions that are made in studies of safe withdrawal levels, such as the percentage of assets invested in stocks versus bonds, whether the stocks are invested in an index fund, and so forth.  Typically, safe withdrawal levels are contingent upon a certain stock/bond mix and broad diversification of a portfolio.

The Four Percent Rule

Over the past two decades, the idea of the “Four Percent Rule” has spread quite widely.  The idea is that one can withdraw four percent of an investment portfolio in the first year of retirement and subsequently withdraw the same amount adjusted for inflation every year.  The inverse of the four percent rule is that one needs to have savings equivalent to 25 times annual spending requirements in order to safely retire.  So, if you have calculated that you need to have $50,000 available for spending in the first year of retirement, you would need to have an investment portfolio of $1,250,000 to support that level of withdrawal in a “safe” manner.

When I first started thinking about the concept of early “retirement”, I spent quite a bit of time researching the topic of safe withdrawal rates and came upon a study that went quite a bit deeper than the four percent rule.  I am not going to link to the study because it has not been updated since 2001 and actually generated some subsequent controversy regarding the methodology that was used.  However, at the time it was the most comprehensive look at safe withdrawal levels that I had come across.  The study looked at financial market returns from 1871 to 2000 and projected the safe withdrawal level for various payout periods based on past history.  A reader could pick their projected payout period and find the optimal mix of stocks versus bonds that would generate a “100% safe” withdrawal level.

The payout periods ranged from ten years, which would only be appropriate for someone who is either already very old or in poor health, to sixty years which was more appropriate in my situation since I was in my early 30s a the time.  I found that the safe withdrawal rate for a sixty year payout was 3.24 percent with a 85%/15% split between stocks and bonds.

The study examined 70 periods from 1871 to 2000 in order to come to the conclusion that a 3.24 percent withdrawal level could be safely sustained for sixty years, with withdrawals rising each year with inflation.  In the vast majority of cases, there would be a very substantial portfolio left at the end of the sixty years. In fact, the median result was that every $1,000 of value in the initial portfolio would end up being worth nearly $43,000 after 60 years assuming a yearly withdrawal of 3.24 percent of the initial portfolio rising each year with inflation.  The worst possible result was that the portfolio would be effectively depleted.

But the main problem with safe withdrawal level studies is that they are backward looking.

It is a major logical fallacy to assume that the next sixty years will look like the period that spanned 1871 to 2000, or anything like it at all!  This is obvious, but it is tempting to look at an overly precise number like “3.24 percent” and assign it with more certainty than it deserves.

No one has any idea what the future will bring or what investment returns will look like, but if we want to make any kind of estimate regarding financial independence, we have no choice but to at least try.  In my mind, this exercise calls for a great deal of conservatism.  I am not comfortable with the four percent rule, and not really comfortable with the 3.24 percent figure that came out of the study.  Part of this is because of the fact that interest rates have been at an unusually depressed level in recent years.  In addition, the level of the stock market implies an “earnings yield” that is far below average.  In a world of savings deposits earning next to nothing, a ten year treasury note yielding just 2.5 percent, and stocks offering an earnings yield under 5 percent, is it really conservative to look at a four percent withdrawal rate as a sure thing?  Would you bet your financial future on it?

The Three Percent Rule

I am not going to propose any specific rule for readers to follow, but I will say that I am comfortable with a three percent withdrawal rate and that is the rate that I used when considering my own financial independence.  This rule implies that you would need to save a little bit over 33 years of annual expenses in order to consider yourself financially independent.  That’s obviously more than the 25 years that is implied by the four percent rule, but it is much more conservative.

Many people would criticize this approach as way too conservative, but is that such a bad thing?  Sure, you might have to save for a longer period of time to achieve independence, but once you do, the level of stress over withdrawal rates will be much lower.  Also, I’ve read criticism of low withdrawal rates along the lines of ending up with “too much” savings at the end of the withdrawal period.  This line of criticism is based on the idea that something big is being given up by under-spending for many years and that ending up with a fat account balance in old age is a negative.  I think this is somewhat absurd for a number of reasons.  First, old age involves facing vicissitudes that younger people might not think of, especially when it comes to nursing care.  Having a pile of cash available to make life comfortable would hardly be unwelcome.  Second, most people want to leave some kind of legacy to family members and providing financial security to others in old age is hardly a negative.  Finally, you can always give away money.  There’s value in generosity and the knowledge that one’s savings can generate benefits beyond personal consumption.

The Bottom Line

The subject of safe withdrawal levels has not been a personal concern for quite some time as the level of my annual spending has declined well below any plausible “danger zone” as a percentage of my available investment assets.  However, I am planning to look at the current research for the purpose of writing about it here and will share any notable information that I manage to uncover.  For now, I would suggest that using a three percent initial withdrawal level is far more reasonable than the much more commonly advocated four percent level and this would imply setting a target of about 33 times annual expenses as a goal for financial independence.

The other factor that should be noted here is that the lower your annual spending requirements, the sooner you can reach financial independence.  Perhaps that is obvious, but it might not be widely understood.  Too many people think about financial independence in terms of replicating their current income in retirement.  This is the wrong way to look at it.  For example, let’s say that you earn $150,000 per year but are only consuming $40,000 per year, which you expect to remain relatively constant in retirement.  You do not need to replicate a $150,000 income in retirement.  You only need to ensure that you can safely withdraw $40,000 per year from your portfolio, and that you can increase this figure each year at the rate of inflation.  Using a three percent rule, this would imply a required portfolio of a little over $1.3 million, which is less than nine times your current $150,000 annual income.

Obviously, no one want to live some horribly restrictive lifestyle either while employed or in retirement, but what is “horribly restrictive” for one person might represent luxurious living for another.  Mr. Money Mustache manages to provide for his family on a little over $25,000 per year!  That figure is going to seem incredible to most readers (it is impressive to me as well) but if you read his blog for any length of time, you will see that it is actually quite possible given his lifestyle and location.  If you only need $25,000 per year, financial freedom using a three percent rule would be around $825,000 in savings.  To be sure, that is still a very sizable sum of money, but as we will see in future articles, the miracle of compound interest makes that kind of savings possible to achieve for many people.