The Two Phases of Wealth Building

Every week I religiously capture the value of each of my investments which I then sum to give me an instantaneous net worth.  This week saw my net worth increase by more than £5,000 without contributing any new money.  For me that is a very large amount of money, and of course Mr Market could take that £5,000 away this week, but it reminded me of the two phases of wealth building that I'm seeing as I'm working to build wealth over a quite short period of time.

The first phase is Building Capital.  As you start on your wealth building journey this is the first phase you pass through.  Here you just want to be adding as much capital to your wealth as quickly as you can get your hands on it.  Saving Hard by Earning More and/or Spending Less will have a much bigger effect in this phase than Investing Wisely.

The second phase is Return on Capital.  Here while Building Capital is still providing a big boost to your wealth it’s now more important to have a stable investment strategy which is very tax and investment expense efficient.  In this phase you could even start to ease of the Saving Hard by for example going part time or taking up that lower paid higher enjoyment opportunity you’ve always desired without moving your financial independence day greatly.

Let me demonstrate the two phases with a simple example (where I’ll ignore inflation) that tries to cover many of the points that I personally live (and have lived) as well as regularly capture on this site.  Average Joe works hard and for his hard work receives £45,000 per year making him a 40% higher rate taxpayer.  Joe wants early financial independence to give the option of early retirement and so starts to think about he might achieve that.  He realises he firstly needs to focus on Building Capital by Saving Hard.  His employer offers a pension scheme where if Joe salary sacrifices 5% of his own salary then they will match it.  There’s some free money there so he goes for it.  Salary sacrificing also brings the benefit of lowering Joe’s taxable salary to £42,750 saving both employee and employer National Insurance.  Joe’s employee NI saved is added immediately to his pension but his employer also generously adds the 13.8% employer NI that they also save.


A good start but Joe takes a step back and looks at the situation this has created.  He is still paying £354 in 40% tax (2014/15 tax rates) but having done his sums he knows that because he only needs £16,000 before taxes and investment expenses to live a happy fulfilling early retirement he’ll only be paying a maximum of 20% tax during that phase of his life.  Joe therefore decides to increase his employer contribution to 7% even though his employer will only match up to 5%.  He is no longer paying any higher rate 40% tax.  Allowing for employee and employer pension contributions as well as employee and employer saved NI Joe’s annual pension contributions have just hit £5,899.

Joe knows that governments love to tinker with pensions and that because he’s young he’s not going to be able to get his hands on any of it until at least 58.  Therefore he decides that’s enough pension contributions and that he also needs to also be saving and investing outside of pensions to bridge the gap between early retirement and pension age.  Always conscious of minimising taxes Joe decides he’s going to save the allowable maximum of £15,000 into a Stocks and Shares NISA.  Between his pension and his NISA Joe is now socking away 44% of his earnings (defined as salary plus employer pension contributions) or £20,899.  After tax Joe now has £16,412 to live on which provides him with a lifestyle he’s happy with.

Joe is very tax efficiently invested and he’s also investing in a balanced portfolio of different asset classes which Joe decides over the very long term should bring him a real (after inflation) return of about 4% as he’s also focused on minimising investment expenses.  Joe also decides that in early retirement he’s only going to draw down on his wealth at 2.5%, to give him a good chance of not running out of wealth in old age, meaning he needs to build wealth of £640,000 (£16,000/2.5%) to be financially independent.

Joe is now set and the chart below shows his 20 year journey to financial independence and early retirement.

Click to enlarge

The green bars (value read from the left axis) represents Joe’s annual Pension and NISA contributions which don’t change - his Saving Hard portion.  The purple bars (value also read from the left axis) represent the annual investment returns that are achieved on his wealth (value shown by the red line with value read from the right axis).

Just look at the early years.  The vast majority is Building Capital by Saving Hard however as time goes on Return on Capital makes a larger and larger contribution.  That’s Investing Wisely and eventually it even surpasses Joe’s Saving Hard contributions.

Save Hard and Invest Wisely to Retire Early.  Success in both elements are critical to success.

As always DYOR.