It’s All About Living Well Below Your Means

I've mentioned previously in passing that as I build the wealth necessary to reach Early Financial Independence I'm noticing that the major wealth contributor for me has actually been the Saving Hard portion of my strategy rather than the Investing Wisely.

Let’s firstly quickly remind ourselves of what each portion contains.  Saving Hard is the methods used to acquire Capital for investment.  For me that is a full time professional career with Megacorp where I’m continually working to Earn More, as well as continually working on methods to spend less, while achieving the standard of living my family desires.  The spending less is typically called Living Below Your Means or LBYM in the financial independence blogosphere.  Investing Wisely is the methods used to maximise return on that Capital.  For me it includes low investment expenses, tax minimisation, modern portfolio theory, tweaking of asset allocations based on market valuations and even my HYP.

The below chart separates the wealth I've personally built each year from both Saving Hard and Investing Wisely.  Every year except 2012 more wealth has been built from Saving Hard.  It even includes the last couple of years where significant monthly savings are given to my better half so that Financial Independence day is synchronised.  So as I alluded to at the start of this post for somebody like myself who’s trying to become Financially Independent in 10 years or so Saving Hard is essential.

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So Saving Hard is important.  Let’s look at each element in turn.  When it comes to Earning More I've been fortunate, having been able to increase earnings by 128% since 2007, however I can also say it has come at a price.  I am also very aware that in the modern continually globalising economic climate where average earnings in the UK are increasing at a less than inflation 1.3% this is currently not easy and importantly is not 100% in our control.  I'm going to ignore Earning More for the rest of this post for these reasons.

On the flipside Spending is very much in all of our control and if we can find ways to Live Well Below Our Means then Financial Independence can beckon in short order.  This is because the more you can LBYM, the more you can save per month (your journey to the goal), as well as the smaller amount of wealth (the goal posts actually coming towards you) you’ll need to build because of that lower spending.  Let me try and quantify this with a simple fictitious example.

Average Jane graduates with a STEM degree, finds a good job and by age 25 while unfortunately not having managed to save anything has fortunately been able to increase her earnings to £40,000.  Here she hits a brick wall with her earnings and is only able to gather inflationary increases from then on.  At 25 Jane also reads Retirement Investing Today, decides Early Retirement is for her and additionally follows some similar Investing Wisely principles to my own allowing her to achieve an after inflation average investment return of 4%.

Under scenario 1 Jane reduces here costs a little and manages to save 10% of her gross earnings at the end of every year.  In this scenario she’s paying £9,845 in tax, spending £26,155 and saving £4,000.  Assuming Jane also intends to spend £26,155* post Early Retirement and decides to settle on a 4% wealth withdrawal rate (WR) in that retirement then she’ll need wealth of £653,868.  Unfortunately this means Jane won’t be stopping work until some time in her 52nd year of saving by which time she’ll be 76 years young.  Under this scenario she better hope State Pension Age is still 68 to bring that date forward.

Under Scenario 2 Jane hunkers down, Lives Below Her Means and manages to save 20% of her Gross Income.  She’s still paying £9,845 in tax but has reduced her spending to £22,155 allowing £8,000 of savings per annum.  Now she only needs wealth of £553,868.  With all other conditions being equal that bit under 52 years reduces to a bit under 34 years where she is 58 old.  That’s Early Retirement which some might be happy with.

Under Scenario 3 Jane really works at it, Lives Well Below Here Means and manages to save 50% of her Gross Income.  Tax is the same but now the spending and saving balance has flipped with savings now beating spending by £20,000 to £10,154.  Wealth required drops to £253,868.  All of a sudden that bit under 34 years is at a bit under 11 years.  Jane hasn't even made the grand old age of 36, is financially independent and has the option of Early Retirement.  It might be for some, is probably too high risk (a 4% withdrawal rate is too high IMHO) and too young for me, but boy does it give her some options for how she lives the rest of her life.

Gross Savings Rate vs Years to Financial Independence for all Jane’s scenario’s and more can be seen in the chart below.

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Enter Average Joe.  He’s identical to Average Jane except he decides that a 20% gross savings rate is his limit.  Instead he’s a super star investor and is going to achieve Financial Independence in less than 11 years through investing cleverness.  What annual investment return does he need?  34%!  A sobering thought indeed.

As always DYOR.

* A quick note on post Early Retirement Spending.  We are of course all different but I know that I will spend significantly less should I enter Early Retirement than I do today.  One area of big savings will be work related costs where as a family unit we spend between 15 to 17% of our monthly net earnings on work related expenses.