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Google sheet that contains list of all WCD lessons and links to all content:
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Recap of Lesson 004 - Retirement
In Lesson 004 we explored several different frameworks on retirement. I argued that the normal framework for retirement (E.G. work until 65 then “retire” and live off social security) is simplistic and doesn’t accurately capture the life progression that someone should aim for.
I laid out my framework on retirement. Effectively, there are 3 financial phases in life which I call “The 3 Phases of Capital.” In addition, there are 2 “retirements” in life. These retirements are the transitions between the 3 phases.
The 3 Phases of Capital
Capital Accumulation
Capital Appreciation
Capital Distribution
The 2 Retirements in Life
Active Retirement (Occurs gradually between phase 1 and 2)
Passive Retirement (Occurs gradually between phase 2 and 3)
Lesson 006 - How Much Capital Do You Need?
Lesson 004 (Retirement) was purely philosophical. Lesson 006 (Passive Retirement) is much more practical and the numbers are much more definitive than Lesson 005 (Active Retirement).
Goal of Passive Retirement
Before we go into the method for calculating how much capital you need, first let’s define what is the goal of “Passive Retirement.”
The goal of “Passive Retirement” is to sustain your desired life style with only the cashflow from the yield on your capital. You should never have to sell assets in order to sustain your life style.
Why is this the goal? This is the goal because it’s sustainable. If you live only off the yield, then your capital never diminishes. If your plan is to sell assets to fund your life style, there is a huge risk that you out-live your money.
How to Calculate the Capital Required
The best way to calculate how much you need to retire can be done in three steps:
Calculate how much money your desired life style costs per year.
Assume a yield that you could get on your future capital.
Back-calculate the amount of capital required in order to live on only the yield of your capital.
Formula
Y = CF / C C = CF/Y CF = C * Y
Y = Yield (In a percentage)
CF = Cash Flow
C = Capital
Example 1
Lets assume the cashflow required to sustain your desired life style is $100,000 per year (CF = $100,000)
Lets assume that the yield you can get on your capital is 5% (0.05)
C = CF/Y C = $100,000 / 0.05 C = $2,000,0000
Example 2
Lets assume the cashflow required to sustain your desired life style is $100,000 per year (CF = $100,000)
Lets assume that the yield you can get on your capital is 2.5% (0.025)
C = CF/Y C = $100,000 / 0.025 C = $4,000,0000
…As you can see, the assumption you make for the yield is very impactful. If you decrease the yield by 2x you need 2x the capital to get the same cashflow.
Complexities
The above calculation doesn’t take inflation into account.
What’s a good assumption for yield???
How to Account for Inflation
As I discussed in depth in Lesson 002 (Purchasing Power), inflation is a hidden tax that central governments impose on their citizens by continuously debasing their fiat currencies.
In the USA, the Federal Reserve has set a target of 2% CPI inflation per year. If you read Lesson 002, you will see that I have rather strong opinions about the current fiscal policy and monetary policy in the USA and I believe the “Real Inflation” is more like 5 to 6% per year and it might accelerate in the future.
Regardless of your political views, you need to factor inflation into your calculations or you are at the risk of your yearly cash flow not being able to sustain your life style for very long.
In order to account for inflation, you need to adjust the formula to the following:
(Y-I) = CF / C C = CF/(Y-I) CF = C * (Y-I)
Y = Yield (In a percentage)
I = Inflation (In a percentage)
CF = Cash Flow
C = Capital
How does this adjust for inflation? You can think of inflation as basically “stolen yield” from your portfolio. In order to offset for this inflation, you need to take that “stolen yield” and re-invest in more capital.
Basically, in order to maintain the same purchasing power of your capital, you need to re-invest at the same rate as inflation.
Example 3
Lets assume the cashflow required to sustain your desired life style is $100,000 per year (CF = $100,000)
Lets assume that the yield you can get on your capital is 5% (0.05)
Lets assume that inflation is 2% (0.02)
C = CF/(Y-I) C = $100,000 / (0.05-0.02) C = $100,000 / 0.03 C = $3,333,333
Example 4
Lets assume the cashflow required to sustain your desired life style is $100,000 per year (CF = $100,000)
Lets assume that the yield you can get on your capital is 5% (0.05)
Lets assume that inflation is 5% (0.05)
C = CF/(Y-I) C = $100,000 / (0.05-0.05) C = $100,000 / 0 C = Infinity
…..wha……?
If you cannot get a yield greater than inflation, then your capital will eventually lose purchasing power.
In the example above, let’s say you had $1,000,000 of capital. This nominal value of capital will stay the same because you are only living off the cash-flow (you aren’t selling any assets). Your nominal cash flow also remains fixed and is $50,000 per year (5% Yield on $1,000,000 of capital). But since there is 5% inflation each year, this $50,000 buys you less and less each year. By year 25, that $50,000 will buy you the same amount as $14,765 did in year 0.
What is a Good Assumption for Yield?
As the example above and the image below demonstrate, inflation has a huge impact on how much capital you need to retire-off-the-yield.
So what is a good assumption then? Well… it’s complicated.
10-Y Treasury
The 10-Year Treasury is often considered the “risk free rate” or the bench mark yield. This means that this would be the lower-bound of your assumption. The 10-Y yield is currently around 1.3% at the time of writing.
30-Y Treasury
You could use the 30-Year Treasury Yield. It has a longer maturation (hence more risk and higher yield to compensate for the risk). Currently at 1.9%.
Dividend Aristocrats
You could invest your capital into the dividend aristocrats. Each of these stocks has increased its annual dividend for 25+ consecutive years. (Note this is the dividend payment, not the yield).
One caution here, a high dividend paying stock is typically a red flag. When you see a high dividend its caused by the share price dropping 99% of the time. Effectively, the dividend cash payment stays the same, but the share price decreases and makes the dividend yield go up.
I would argue many of the dividend aristocrats are risky stocks to own and have a high likelihood of seeing significant stock price drops in the future. Many of these dividend aristocrats are the old-guard. They were the once-great companies, but they have paid out dividends instead of investing in innovation. As such, their business models or technologies are getting disrupted and they will be on a slow and steady decline.
Companies like ExxonMobil refuse to cut their dividend no matter how dire the situation. ExxonMobil literally laid-off 50% of it’s staff last year…. but no dividend cut.
As such, I would be cautious with the dividend aristocrats. If you were to average this list, the average yield is about 2.0 to 2.5%.
At this point, I’m sure you are getting discouraged.
10-Y Treasury = 1.3%
30-Y Treasury = 1.9%
Dividend Aristocrats = 2% to 2.5%
If “real” inflation is about 5% per year, then what options do you have? Fortunately, there are some decent investments left that are accessible and provide good cash flow.
Real Estate - Rental Properties
Real estate is still a relatively good option. That said, rents are not keeping pace with housing prices, so yields are dropping.
Rental Example - 1% House - (Monthly Rent / Purchase Price)
House Price = $100,000
*Rent = $1000 per month ($12,000 per year)
Operating expenses (property management, repairs, taxes) - Roughly 20% of Rent
Vacancy - Assume 10% of rent
Cash Flow = Rent - Vacancy - Operating Expenses = 70% * $12,000 = $8,400
Yield = $8,400 / $100,000 = 8.4%
Pretty good!
A $1,000/month rental for $100,000 is very hard to find these days. This is the magic 1% house (Monthly Rent / Purchase Price >= 1%…. then it’s going to cash flow well).
Even in good metros like Houston, Memphis, Birmingham… you might only find houses that are 0.6% to 0.9% (Monthly Rent / Purchase Price).
Rental Example - 0.7% House - (Monthly Rent / Purchase Price)
House Price = $100,000
*Rent = $700 per month ($8,400 per year)
Operating expenses (property management, repairs, taxes) - Roughly 20% of Rent
Vacancy - Assume 10% of rent
Cash Flow = Rent - Vacancy - Operating Expenses = 70% * $8,400 = $5,880
Yield = $5,880 / $100,000 = 5.88%
Not Terrible!
A great side-benefit of real-estate is that they are an inflation hedge. Typically home prices have out-paced inflation. So if inflation does decrease your cash-flow purchasing power, at least your capital is appreciating.
Small and Medium Businesses (SMBs)
There are plenty of other investment opportunities to get a good yield. As I’ll discuss in the next section, all of the easy investments or liquid investments that provide yield have been in high demand since 1980 and yields have declined.
That said, there are alternative investments such as:
Laundromats
Cash Washes
Gyms
Nail Salons
Etc.
These aren’t the sexiest investments and definitely aren’t 100% passive, but some of them have much higher yields. I have yet to invest in any of these, but if I do, I’ll report back in a future lesson.
The one I’m most interested in at the moment is buying a Laundromat. Some high level numbers I have heard is that laundromats sell for a 3-5 price to earnings multiple. This means than a laundromat that has $33k to $20k in profit (not sales) per year would sell for about $100k.
Example:
$100,000 purchase price
$100,000 in sales/revenues
$70,000 in operating expenses
Profits = Cash Flow = Revenue - Operating Expenses = $100k - $70k = $30k
Yield = $30k / $100k = 30% (Now that’s good!)
P/E multiple = Purchase Price / Earnings = $100k / $30k = 3.33
This sounds a bit too good to be true. I’m sure there are risks or complexities that I will learn of, but the yield is too enticing for me to ignore.
What Do I Use For My Yield Assumption?
I use an effective yield of 3% (that is I’ll be able to outpace inflation by 3%). If inflation is 5%, then I believe I’ll be able to get 8%.
Yields Have Decreased Over Time
Something I will discuss in a future lesson is how the monetary and fiscal policy since the 1980’s has caused a deflationary-debt spiral that has made yield harder and harder to find.
Below is an image of the 10-Year Treasury Yield since 1960. Many analysts use the 10-Year yield as the "risk free rate”.
At a very high level, you can think of it like this:
The coupon payments (the cash flows) of assets have stayed relatively fixed (CF)
The price of these assets has dramatically increased (C)
Therefore, the Yields have dramatically decreased (Y = CF/C)
Very Simplistic Example:
Year 0
House Price = $100,000
Rent = $1000 per month ($12,000 per year)
Yield = $12,000 / $100,000 = 12%
Year 10
House Price = $300,000
Rent = $1000 per month ($12,000 per year)
Yield = $12,000 / $100,000 = 4%
Effectively, since about 1980, wealthy investors have been chasing assets that provide a good yield because yield ensures a consistent life style. The cashflows haven’t changed a lot and the supply hasn’t increased much. The increased demand has driven the price up making the effective yield much less.
Summary
“Passive Retirement” is the final stage of retirement where you can let your capital do all the work in generating the cash flow required to sustain your life style.
The goal of “Passive Retirement” is to sustain your desired life style with only the cashflow from the yield on your capital. You should never have to sell assets in order to sustain your life style.
In this article we:
Reviewed how to calculate the amount of capital required to reach “Passive Retirement” given the yield, inflation, and your yearly life style expenses.
Reviewed different investment strategies to obtain yield on your capital.
Discussed how yields have been in secular decline over the past four decades and why this will likely continue.
Reference Material & Social Media
In Lesson 030 I cover how to navigate and utilize the Google Sheet I have built for all WCD lessons. This Google Sheet contains a worksheet for each WCD lesson. Each sheet has all of the Excel calculations, tables, graphs, and charts that I have posted in the respective WCD lesson. Additionally, the Google Sheet has a master “Index” worksheet that has links to all of the content associated with each lesson.
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