Early retirement and financial independence have become increasingly popular concepts. Back in 2009, I first became aware of a growing movement among young people to save aggressively and live simply in the hopes of retiring in their 30s or 40s - a concept that still strikes many in the mainstream as bizarre. A few bloggers have built a small media empire on the topic, with the most popular being Mr. Money Mustache. His argument is that a simple life and a high savings rate bring both more happiness and a greater sense of freedom than the more conventional 40-year career and steady retirement planning that was the norm for Baby Boomers.
Now, many young people are attracted to the idea of escaping the rat race with a high savings rate and an early exit from their careers. This can be seen in Google searches for financial independence, which have spiked recently:
In some cases this is probably more a result of burnout or frustration with modern working conditions. If that is the case, perhaps these young people don't need to give up on their careers forever - perhaps they just need a few years of passive income to fuel an alternative lifestyle.
The financial metrics of such a decision are vastly different, and are rarely discussed in the financial independence/early retirement blogosphere. Focusing on conservative investing to build a nest egg that can last as much as 50 years or more, they ignore more aggressive and higher risk options to getting out of the rat race quickly. But there is an alternative for those who are not looking to build a nest egg that will last forever - just an income stream that will allow them to check out of the real world for a few years.
To illustrate this point, let's imagine a 25-year old millennial professional earning $70,000 per year after tax with an after-tax savings rate of 65%. This millennial is spending $24,000 per year on living and saving the rest. Let's call her Jane.
Since income growth is increasingly rare in the upper middle class, let's assume that $70,000 will stay constant. Let's also assume a 2% inflation rate per year. This might sound low to people who remember the 1970s and 1980s, but we've actually had a lower 1.7% CAGR increase in the CPI over the last 10 years:
With demographic headwinds, inflation is likely to remain low for a while to come. This was a controversial idea just a few years ago, but mainstream economists and the Fed are beginning to accept it as truth. So 2% it is.
With these assumptions, Jane will be able to get enough passive income to cover her expenses in 5 years if - and this is a big if - she can get an annual return of 8.2%:
An 8.2% return over 5 years sounds impossible, but the S&P 500 (NYSEARCA:SPY) has actually yielded an annualized total return of nearly double that in the last five years - 14.55%:
I know, I know - we're heading for a correction, the market is overpriced, the Fed is going to take away the punch bowl. I've been hearing and reading these assertions almost daily for the entire period charted above. Maybe this time is different, maybe not; but for now, let's assume the S&P 500 will have a performance 57% of the last 5 years. Since we're talking about a 25-year old investing heavily in 100% stocks, I think the higher risk of such an approach is more tolerable than if we were talking about a more conventional approach to retirement.
When the nest egg has grown to provide enough income to cover expenses assuming an 8.2% return, what can we do? We could stick with the S&P 500 and rely on capital gains and dividends to get us the income we need, but then we have to worry about transaction costs, selling during a downturn, and so on. I'd rather get that 8.2% entirely from dividends.
I can easily do that from closed-end funds and high dividend stocks. So, Jane will need to sell her S&P 500 holdings when she turns 30 and buy these other alternative and riskier funds to get her the income she needs. She also needs to be prepared for the possibility that her income will fail to suffice as a result of dividend cuts in her holdings. So let's build a portfolio of funds with higher than 8.2% dividends and no history of cuts. In fact, let's look for funds who have increased payouts over a 2% annualized rate in the last 5 years.
I can do this with 4 stocks: Main Street Capital (NYSE:MAIN), AGIC Equity&Convertible Income Fund (NYSE:NIE), PIMCO Dynamic Income Fund (NYSE:PDI) and PIMCO Dynamic Credit Income Fund (NYSE:PCI). These are exposing me to large-cap stocks and convertible bonds, middle market loans offered by a BDC, mortgage-backed securities (PDI, PCI) and high yield corporate bonds (again PDI and PCI). This isn't ideally diversified, but it does provide Jane with a track record of dividend growth and enough of a yield to cover her expenses:
In fact, the yield of this portfolio, with conservative assumptions about special dividends from PCI and PDI, is over 10%. If Jane's holdings cut their dividends by 20%, she will still have enough income to cover her expenses.
That is, of course, until we consider inflation. Inflation is covered by the funds' dividend growth, and of course if that stops, the portfolio will not cover her higher expenses. She will have to go back to work, possibly getting a part-time job to cover her expenses.
Now let's really throw caution to the wind and assume that the next 5 years will offer the same return as the last 5 years. And let's also assume Jane will be able to get that 10.34% portfolio yield in 5 years. Now she can quit her job at 29:
This is an extremely aggressive, optimistic and high-risk perspective. But the purpose of this exercise isn't to demonstrate how to build an extremely safe portfolio that will last forever. It's an exercise to show how a young upper class wage slave can escape the rat race in 5 years, admittedly with a higher possibility of failure than a more conservative approach to retirement.
But I think Jane is smart enough to figure out how she can cover income gaps with all that free time she'll have away from the rat race.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in PCI, PDI over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.