The Many Choices on your Journey to FIRE

There are always plenty of discussions in the FIRE community about the best way to get to FIRE but there’s no one right answer. I thought I’d talk a little bit about some of the different choices to make, how they work, and who they might work best for.  Many of these choices also affect the other choices you make so it can be a bit complex!  This is going to be a long post so prepare yourself!

Investment structures

The main ways of holding your investments that I’ve seen are in your own name, in joint names if you have a partner, in a company, in an investment bond, or in a trust.  Superannuation is another option but given you can’t access it until you’re 60 that probably doesn’t help much for the RE part of FIRE.  There are lots of pros and cons to each way of doing this, most of which are covered in this post over at Lifelong Shuffle so I won’t go into it too much. 

Some of the things you want to keep in mind will be the taxation on your investment structure now as well as the taxation on your investment structure in the future, both when you are retired and if someone takes a break from the workforce to have kids.  If you’ve got a spouse who is at home looking after the kids then having all the investments in their name may make sense now because they have a nice big tax free threshold to work with whereas you’re already getting taxed at 39.5%.  But if they go back to the workforce and when you declare FIRE all those investments are in one persons name and you only have one tax free threshold to use.  Using a trust allows you to be more flexible with the tradeoff of additional costs and complexity.

For a lot of people holding it in their own names or joint names is going to be just fine and keeps it nice and simple. For others seeking asset protection or who have children or other parties or they will be able to distribute income to then a trust may make more sense.  Investment bonds and companies may also make sense for some people, but for the vast majority either single or joint names is fine. Having trusts adds flexibility but has additional costs.  There is no one right answer and FIRE can be achieved using pretty much all these options, however it may take longer to get there or not be optimal from a tax perspective.

Income strategies

How are you going to get the money to fund your early retirement is obviously a pretty important question, and there are a number of different approaches.  Two of the main ones for share investors are the Bogle and the Thornhill approaches, named after Jack Bogle who founded Vanguard and Peter Thornhill of Motivated Money.  The summarised versions of these are that the Bogle approach says to build up your assets over time and then sell them down to provide income, the Thornhill approach is to live off the dividends from your investments and not worry too much about what happens to your capital.  Bogle comes from the US where selling shares probably makes more sense for tax reasons, in Australia living off dividends is easier because of the higher dividend yields and franking credits. 

Another approach is living off income from other assets like investment properties or fixed income.  Given the low rental and fixed income yields in Australia at the moment this may require having more assets than a Thornhill equity approach would, but along the way you’ve likely used more leverage to buy property so it might have helped out there.  You could also potentially build up your property or fixed income holdings over time and sell these off ala the Bogle approach.  And obviously you can combine the different approaches as well.

Each of these approaches also have drawbacks.  Depending on how much income you need Bogle approach requires you to sell shares even if the market has crashed, and you may be up for CGT if it has gone up.  The Thornhill approach relies on dividends and franking credits continuing to work the way they do.  Using rental properties means you have to keep those properties rented out all the time which isn’t always the case.  Using income from bonds or term deposits for income means you want those rates to remain the same, which they don’t.  If you want to sell them, then you have CGT potentially. Again there is no right or wrong answer to the best way to get your income, just a series of different options with different drawbacks and tradeoffs. 

Investment strategies

What investments you make obviously has to take into account your income strategy, and vice versa.  If you want to live off income from your assets then you’re going to need to invest in assets that generate an income stream.  If you’re happy to sell assets down over time then you don’t care as much about the income as the growth.  The major asset classes most people look at are Aussie shares, International shares, Australian property, and Fixed Income.

The Australian sharemarket has about a 4% dividend yield, grossing this up using franking credits gets you to about 5.7% so on a pre tax basis for every thousand dollars you have invested in the broad market you get about 57 dollars in income, plus whatever capital growth/loss you receive.  Adjusted for inflation dividends have held reasonably steady over time, although they tend to drop a bit in busts and go up a bit in booms.  This lends itself fairly well to the Thornhill approach of living off your dividends and not worrying too much about what happens to your capital.  There are also ongoing debates about buying index funds vs Listed Investment Companies (LICs) or just a diversified portfolio of individual shares but I’ll leave that discussion for another post potentially.

International sharemarkets tend to have higher growth but much lower dividend yields of around 2% to 3%, so if you were to use the Thornhill approach then you need much more in the way of assets, however it is ideal to some extent for the Bogle approach.  You tend to get a much more diversified set of assets with International shares rather than the Financial Services and Resources dominated ASX, but you may also be taking on currency risk depending on how you get your international currency exposure.

Australian property can take a number of different forms such as purchasing real physical property like investment properties, or buying REITs or unlisted property trusts as well as commercial property etc.  Rental yields on residential properties tend to be pretty low in the major cities but are a bit higher in rural areas. 

One of the downsides of buying a single (or even multiple) residential property is the lack of diversification and divisibility, plus the need to have a very large amount of money for a deposit let along buying the entire house.  On the plus side it is generally relatively easy to get leverage against it which can both help and hurt returns. 

Investing in real property probably lends itself more towards living off the rental income rather than selling down over time due to the large value of each property and the lack of divisibility.  Investing in REITs or unlisted property trusts tends to give a higher income from rents, allows for divisibility and is well diversified but for a variety of reasons a lot of people tend to prefer to own a single residential investment property instead.

Fixed Income can incorporate securities such as bonds but I’ll also include term deposits in this.  These tend to be lower returning investments than shares or property, but are also less volatile and generally in some sense at least safer.  With current interest rates around the 3% mark though you need a lot of them to provide your income though, and inflation will also eat away at that 3% return pretty quickly.  They are a good diversification tool and are useful for letting you ride out any crashes in your other investment assets.

So all of these different asset classes have different ways of investing in them, different pros and cons, and may or may not work for you psychologically as well as financially.  A lot of people can’t handle the constant volatility of sharemarkets and if you can’t sleep at night because you’re worrying about it then it isn’t for you.  It’s also entirely possible to have a combination of these investments and that is what a lot of people do.  You have to figure out what works for you both financially and psychologically, there isn’t just one way to do things.

Leverage or no leverage

Another decision to make is whether to use leverage to help you build your wealth.  Leverage is basically borrowing money to invest with the hope that the returns on this will be better than the cost.  Typically if you’re buying investment properties you will need to use leverage unless you can stump up very large amounts of money in one go.  You can also borrow against your shares and most other assets, but most people don’t. 

Leverage magnifies your returns, so if things go up then it helps a lot, if things go down it hurts a lot.  It’s not something you need to do (with the likely exception of the above mentioned example of buying investment properties) but it may help you get to FIRE faster if things work out. 

What type of FIRE do you want?

The three main categories are Lean FIRE which is living on a pretty low income and keeping living costs to a minimum without much in the way of luxuries, Regular FIRE which is Lean FIRE with a few more luxuries added on, and lastly Fat FIRE or HI FIRE as I prefer to call it which is having a pretty high income once you have FIRE’d.  Lean FIRE is generally a lot quicker to get to but there is less of the nice stuff. Regular FIRE takes longer but you have more of the goodies and more room to cut costs if it becomes necessary.  Fat FIRE is lots of the goodies and plenty of room to cut costs if you need to but takes a fair bit longer to get to.  Which one is right for you is going to depend very much on what tradeoffs you are willing to make.

Do you want to have kids?

This one is a huge decision to make, and ideally it’s a decision that you make in advance rather than having thrust upon you.  Kids are awesome (most of the time anyway!) but all else being equal they do cost more money than if it is just yourself or just you and your partner.  You need to factor this into what your basic living costs are going to be and therefore how much money you will need to hit your FIRE number.  Given it’s obviously a pretty personal decision I’m not going to write any more about it here but it is definitely something you want to be thinking about and taking into consideration.

Simplicity vs complexity

Keeping it simple has the very obvious advantage of being as the name suggests, simple.  If it’s just you or you and your partner, you’re both working and in roughly the same tax bracket, you don’t plan on having kids, you only want to go with one investment strategy etc, you both want Lean FIRE then happy days.  You can probably go with something like investing in joint names, put it all in one asset class or some sort of balanced fund and use either the live off the income or sell down over time approach, don’t need to save as much and boom you’re done, happy days.  No need for anything too tricky, no need for help with your tax return or anything like that.

That covers a lot of people, not least because a lot of the FIRE community seems to be working young singles or couples with no kids and at this stage no plan to have kids. 

But if your situation isn’t that straightforward then more complexity could be optimal.  An example of this would be if you’ve got a partner and one of you isn’t working because they’re looking after the kids but they will go back to work at some stage, and you don’t want to have all your eggs in the one basket when it comes to investments.  You also want direct control as well as some asset protection, you may retire at different stages and overall things are just not real simple. 

In this case you may want a more complex setup to optimise your situation all the way through your FIRE journey.  A couple in this scenario may want to look at investing through a trust so they can give the income to the spouse who isn’t working at whatever time, maybe distribute some to the kids when they become adults but don’t have much income, and some asset protection if that’s important to them.  This is actually pretty similar to my own situation and is something that’s I’m looking at currently.  All of this comes at an extra cost though, both in terms of time and money and you have to decide if this is worth it to you.

So keeping it simple tends to keep fees down and is easy to understand, but isn’t as flexible and may not be as efficient as a more complex solution.  Again there’s no right or wrong answer, there’s just what works for you.  In an ideal scenario, and in fact in a lot of cases, you don’t have to make those tradeoffs but in some you do. 

Summary

As you can see there are a lot of different choices on how to get to FIRE plus there are plenty of others I haven’t mentioned, and as is usually the case there may be tradeoffs that you may have to make.  There’s no one universal right answer and you need to decide what choices best suit you!

What choices have you made on the road to FIRE?  If you liked this post and would like to read more like it then please subscribe using the link on the right!