I'm broke, now what? - A basic financial plan

I was talking to my friend Adam the other day and he said that he liked the blog but what do you do when you are 30 and haven't even begun to prepare to think about the end, i.e. financial independence (FI). Ahhhh, good question.

My first response - don't sweat it. And my second response is - sweat it. The first response is based on the theory that God is ultimately in charge of taking care of us. In the Bible Jesus teaches us that it is much more important to focus on things that have eternal value than to worry about where our next meal will come from. Focusing on God, relationships and helping the poor are areas that would fit that bill.

The second response is based on the non-biblical but prudent advice that God helps those who help themselves. Financial independence is not about being rich but about giving you options as to what to do with your time. Full financial independence means that your assets (real estate, stocks, bonds, mutual funds, etc) are generating cash flow that fully supports your lifestyle. Every single retired person who doesn't work is fully financially independent. The question is - What type of lifestyle do you want to live?

As I mentioned before our ability to work into our 70's and 80's is increasing rapidly. Most people don't want to just sit around and watch TV. or go fishing. Some want to travel, some to start a consulting business and some to keep doing the same job albeit at a slower pace. The idea here is that you need to at least think about your goals and then make a rudimentary plan to reach them.

Step One: Decide what kind of life you want to live. This includes where you want to live, leisure activities, travel, etc. It also includes medical expenses, long term care and estate planning.

Step Two: Decide when you want to live this life. Essentially at what age do you want to have the cash flow from your assets to meet your lifestyle needs.

Step Three: Take a stab at how much your planned for lifestyle will cost at the time you want to be living it. There are a couple of ways to do this. One is to take your current lifestyle (if that is what you are aiming for) and estimate that it will take 50-90% of your current income to give you the same lifestyle in retirement depending on your lifestyle choices. It usually takes less due to reduced taxes, less mortgage debt and other work related expenses.

Step Four: If your financial independence day is far off into the future you also need to figure in inflation. Count the number of years until financial independence (FI), choose a reasonable inflation rate (too risky=2%, too safe=8%). I like to choose 4% in my models. Multiply your income needed monthly by 1.04^(# of years until financial independence)

Step Five: Determine what automatic income sources you will have at your FI age. This includes pensions and social security mostly.

Step Six: Subtract your automatic income sources from your projected monthly income need. The result is the amount of money that your investment income must produce.


Example:

Step One: I want to live a lifestyle that is better than my current one. I expect some salary growth as a teacher that will beat inflation and that in retirement I will want to travel and give away more money.

Step Two: I want my financial independence to come at age 55.

Step Three: I will base these numbers on 100% of my current income of $42,000 since I expect my income will rise over inflation and my lifestyle will increase (I will probably spring for cable someday and I have a long way to go on my goal of giving away $1 million).

Step Four: I have 25 years to secure an income that is worth $42,000 in the year 2032. Using my formula above 42000 x 1.04^(25) = $111,966 / 12 = $9331/month.

Step Five: I will have a pension that pays me 50% of the average of my final 3 years salary (that is why I am a teacher). Let’s estimate that at 50% of $108,000 or $54,000. I am not counting on Social Security for anything.

Step Six: $111,966 - $54,000 = $57,966 /12 = $4830 in investment income needed per month.

So this becomes my goal. In order to reach financial independence at age 55 my investments need to generate $57,966 per year or $4830 per month. That is my goal. For someone not as fortunate to be a teacher then your goal for my lifestyle is probably double -- $115,930.25 per year or $9,661 per month.

Next time we will talk about a plan to get there.