A Cash Flow Management Strategy For Financial Independence
Believe it or not, I’ve written this post a couple of times. I’ve never published the previous versions because I’ve never been happy with how the post came across. Cash flow management is one of those topics that’s hard to put into words without sounding like some kind of arrogant know-it-all.
I honestly DON’T know-it-all and my cash flow management strategy is really based upon this fact. That’s the honest truth.
Historically, there are two ways to approach cash flow management when you live off your assets. None of the approaches are necessarily right or wrong, but there are certain advantages and disadvantages to consider between the various approaches.
The two main cash flow strategies:
- Sell assets on a regular basis to fund living expenses. Essentially this a drawdown strategy similar to IRA required minimum distributions where the asset balance is designed to eventually decline to zero. If there’s enough capital appreciation in the portfolio the balance could potentially even rise, but I can’t predict the future so growth rates might not keep up with portfolio withdrawals.
- Live off the income generated by assets. Under this strategy the investor focuses on investing in high-income yielding investments rather than capital appreciation. While this strategy does generate a lot of income it might be trading off long-term growth for short term income. Depending upon how long you live and future inflation rates, this strategy could run into problems too.
Neither of these strategies is perfect and can run into problems under certain economic conditions. If you read about these strategies on the internet, the folks who prescribe to either of them tend to get pretty worked up in defence of their chosen strategy. Much like a religion.
I don’t have any skin in those two games, so I find it humorous to read the various defenses for each strategy. They tend to sound like arguments with my 3-year old.
“The Trinity Study says the 4% rule is safe, so I only need 25 times my spending to withdraw a regular 4% to live off. Long term stock market growth rates will ensure I’ll die a very rich person.”
Yeah, OK. Sure. Did you also know that the Trinity study only covered time periods in American history when economic growth was far greater than today? The study covered 1925 to 1995, a period of unprecedented growth. Slightly larger and longer studies have shown that this “American Experience” might actually be an anomaly. Furthermore, the world has changed considerably since that study was conducted….
With the United States GDP growth rate trending downward over the last…. oh, half dozen decades, birth rates reaching record lows, an anti-immigration agenda in the White House, and slowing productivity growth, it seems unlikely that any portfolio could be reliably withdrawn at rates the Trinity study suggested.
Even Jack Bogle (founder of Vanguard) believes future returns will be lower. He guesstimates future stock market returns will average about 4%.
“As long as my regular expenses fit within my high-yield portfolio income, I’m financially free. I don’t need to work!”
So said every pensioner ever throughout history… and then things got tight. While this “high yield exceeds income” strategy might work today, there’s no guarantee it’ll work tomorrow. For one, inflation can really eat away at bond interest income or stock dividends over time. After a couple of decades what might have felt like a comfortable retirement suddenly feels like a impossibly tight budget.
Remember: Bond income does not grow unless you reinvest MORE capital on a regular basis, and stock dividends are not guaranteed to rise at rates faster than inflation.
Many real world pensioners have run into this problem when the payouts from their pensions haven’t kept up with real world living increases. Go talk to a few if you don’t believe me… they get very passionate about cost of living increases.
Secondly, the dividend income from the high yield stocks favored by the “income” crowd tends to grow at slower rates than low yield stocks. Primarily this happens because high yields stocks have high payout ratios. Because so little cash is reserved for reinvesting in the business, dividend income levels don’t tend to rise quickly. In contrast, low payout ratio stocks tend to have dividend income that grows quicker because more cash is retained for reinvesting in the business.
Sounds logical, right? This is one of the first hints that a cash flow strategy with some kind of balance might be intelligent.
One area that’s worth considering is taxes. Most of the world pays taxes on portfolio income. Both dividend income is taxed and capital appreciation is taxed. When saving, the advantage falls toward capital appreciation because capital appreciation is taxed only when you sell. Dividend income is taxed in the year you receive it.
(Tax rates on dividend income and capital appreciation can vary significantly — make certain you understand how much you’ll be paying in taxes under each strategy)
So, should we just go with strategy #1 and invest in all non-dividend paying stocks to completely avoid taxes? Well, maybe not…
The world isn’t always a straightforward and simple place. Saving up to financial independence level sums isn’t easy — There will typically be “income breaks” between when you start saving and when you finally reach financial independence.
Job losses happen at inconvenient times. Accidents (by definition) always seem to happen at inconvenient times.
Is that a good time to sell stock? Sometimes there are absolutely terrible times to sell stocks. If you sell during a deep recession (when stocks are down) you might be sell at the absolute worst time. Often such recessions coincide with job loss. This is one of the main weaknesses with the “Sell Assets” strategy.
Sometimes it’s nice to have a little dividend income to bridge those income gaps too.
This is very personal and it’s going to be entirely dependent on your job and life situation. Don’t let some random guru on the internet tell you to invest in stocks that don’t pay dividends for sake of avoiding a few taxes. Sometimes there are more important things in life… like eating, paying medical bills, or having enough cash to put gas in the tank so you can get to that next job interview.
Trust me, I’ve been there folks.
Remember that chartI tossed up from my last post when I said I’ve held those shares for 17 years? Yeah, his chart:
Yeah, I was once *this close* to selling those shares to pay my rent. Thank you dividends for bridging the income gap for me.
This real life experience led me to the conclusion that taxes (or avoiding taxes) should not be the primary consideration when designing a post-FI cash flow management strategy.
Taxes should merely be one consideration when designing a cash flow strategy — not the deciding factor.
Look at it this way: Tax rates are GOING to change. If any strategy you create now is based entirely upon our current tax rates, you’ll be changing strategies every few years.
Then, The Game Changes
So you’ve finally reached “Financial Independence” and you’ve got a good sized portfolio. Congratulations!
This is when game begins to change. Instead of accumulating, you’ll be withdrawing!
If you’re going to regularly start withdrawing money from your accounts (like I do), the tax differences between dividends and capital appreciation in this situation becomes fairly negligible. For most people in the U.S. you’ll be paying either 0% or 15% taxes on dividends and capital gains depending upon your income level.
(There are exceptions to this even in the U.S., but for now let’s avoid going down that rabbit hole.)
Instead, let’s try to focus on what’s important…
Income to fund necessary lifestyle expenses. At this point you should have a fair understanding of what your lifestyle costs. Your combined dividends and capital gains should exceed this amount and still provide enough to cover inflation, emergencies, market fluctuations and a very long lifespan.
Compounding. In order to fund a financially independent lifestyle into the future (possibly 40 years or more) you’ll need to be absolutely certain that compounding is happening. I cannot emphasize enough just how important this little point is.
Our Hybrid Cash Flow Management Strategy
Occasionally I’ve been accused (incorrectly) on the internet of following a high-income strategy, because I write about dividends a lot. This is actually incorrect. We may generate a lot of dividend income, but our post-tax portfolio yields slightly less than 3%.
(We don’t currently withdraw from our pre-tax retirement portfolios, so they’re essentially yielding 0% right now.)
From time-to-time, I do find good deals on preferred shares that bump-up our portfolio yield considerably, but this is typically short-term in nature.
My cash flow management solution is actually a hybrid between the two main strategies. I strongly believe that both dividend income AND capital appreciation are required for a successful long term FI portfolio.
Here’s how I go about making sure that happens:
1. First of all, 25 times spending (or the 4% rule) isn’t going to cut it. I decided we needed significantly more than that to cover long term market declines, sequence of return risk, and a sustainable long term withdrawal rate under current conditions. We want 3% or less. Right now we’re over $3 million+ in assets and have a withdrawal rate of 2.3%.
2. Dividend income should cover regular living expenses with low payout ratios — Food, clothing, shelter, healthcare, entertainment, and energy. All the usual lifestyle stuff we pay for on a regular basis. The dividend income ensures we don’t need to sell assets at inopportune times to fund our lifestyle.
Capital gains are not required to cover our expenses, but I want dividend payout ratios less than 60% of net income.
In 2017 our dividend income was $53k — this didn’t quite cover all our expenses. Thankfully, it’s only a temporary problem due to the extreme high-cost of daycare. Our expense level will begin declining this fall when Tako Jr. starts school.
Meanwhile, I’m working hard on growing our dividend income this year.
Any unusual and irregular expenses such as new cars or expensive home repairs will be paid for out of our emergency fund. If our emergency fund doesn’t cover that amount, we’ll cherry pick the best assets for selling. In some situations we may defer these unusual expenses until better market conditions apply.
3. We maintain an emergency fund equal to at least 2 years of expenses in a money market account. Under most situations this cash is a buffer between lifestyle and fluctuating market forces. We don’t want to be eating shoe leather and cat food if the market goes through a really rough period. Some lifestyle flexibility may be required however.
4. We desire a balance between capital appreciation growth and dividend income growth. Over time, I require both of these growth rates to exceed the rate of inflation. Any investment that doesn’t meet this requirement will be sold. Dividend payout ratios should also be maintained at reasonable levels — typically less than 60% of earnings. If we hold bonds or preferred shares, half of the interest income should be retained for reinvestment.
5. Both internal and external compounding need to occur. This will guarantee the success of our compounding machine. What do I mean internal and external compounding? If you recall from some of my older posts, there’s several different kinds of compounding that occur. The main ones we care about here are:
- Internal Compounding— The compounding which your investments do themselves internally.
- External Compounding — The compounding you do yourself when you reinvest excess cash.
I’ve worked at enough Fortune 500 companies to know that internal compounding doesn’t always happen. Many millions of dollars are regularly pissed away on stupid projects that will never-ever generate shareholder returns.
Sad, but true.
We can only guarantee external compounding because we perform this operation ourselves. This may require dividend income that exceeds our expenses, or the occasional capital gain harvesting when Mr. Market prices assets excessively.
As far as internal compounding goes, it’s more of a monitoring situation. Monitoring compounding in investments is tricky at best, but over time it becomes noticeable — Free cash flow should grow over time when significant earnings are retained. Dividend income should also grow along with that free cash flow. We’ll monitor our investments to validate internal compounding over a rolling 3 to 5 year period.
Like I said earlier, I have absolutely no ability to accurately predict the future. This is merely the cash flow management plan I’m using to help smooth out the bumps.
Unless you’re deluding yourself, you probably shouldn’t believe your crystal ball is any better than mine.
Who am I to question your future predicting abilities though? Maybe you really do have a magic ability to predict the future! (In which case, please send me an email)
Either way, it’s the future that will make or break your cash flow strategy. Today shouldn’t be your concern.
When designing your own cash flow management strategy, design with the future in mind — Market volatility, recessions, dividend cuts, changing tax rates, much higher inflation, car crashes and even tornadoes hitting houses could all be possibilities. Whatever!
The question isn’t if change is going to happen (it definitely will). The question to answer is, will you be prepared?
28 thoughts on “A Cash Flow Management Strategy For Financial Independence”
Awesome post and analysis. I’m also targeting a 3% rule or even lower. I’m there now actually, at my current spending levels. But ideally I’d like to spend a bit more in the future and still be at around a 2.5% withdrawal rate.
A hybrid approach is obviously the best as I see it. I’m not sure exactly the mix I would target for dividend income versus cap appreciation. But I have plenty of time to figure it out as I’m still part-time employed and bringing in a good salary. I’m still building my portfolio, and if all goes well my side hustles will pick up that slack before I fully retire from W2 life 🙂
Thanks Accidental FIRE! Nothing wrong with a little “part-time” employment either!
I’m fully with you on this approach. We are diversified into a number of different income / asset producing streams, and I wouldn’t feel comfortably FI until we were well below a 4% withdrawal rate. That said, having a good amount of slush in your annual expenses helps to be flexible if need be. At the point we’re looking at real early retirement (if we ever fully go that path), then we’ll want a hefty cash amount as well.
I agree. All too often I see people with hyper-optimized budgets trying to retire early on 4% and I wonder, “Where can they cut in that budget?”
I’m rather worried for them when I see it.
I’m with you on the hybrid approach. Capital growth to offset inflation and dividends & cash cushion to cover us during bear markets. Seems to be working great so far! Our 4% withdrawal rate even went down to 3.1-3.4% as our portfolio increased and our costs went down in retirement. Location independence helps a lot. What really opened up my eyes after retiring is how much your cost of living changes depending on the location–sometimes even in the same country. So that’s one huge bonus of retirement–you’re no longer tied to a job, so you can move. And for those who don’t want to, they’ll need to work longer but hey, if the trade off is worth it, they can choose to do that. Having choices is awesome, isn’t it?
Yup! We plan on moving to a cheaper location at some point. Nothing much tying us here anymore!
We have a blended solution too. Our dividend income is from our taxable account. We leave our retirement accounts alone to compound for now. A big factor for us is post-retirement income. Any little bit helps a lot. Once we’re closer to 50, we’ll evaluate the situation again. Less time in full retirement means less uncertainty.
You make quite a bit of income from your blog Joe and that helps a lot. I wish I had that problem! 😉
My blog only manages a “pittance” so I have to rely a lot more on income from my investments.
A small side income is also hugely beneficial to the whole process – I find that getting from 4% to 3% is far easier using a bit of income to buffer it in early years, as it equates to hundreds of thousands of $ with a few more years of work, vs a very manageable side business that generates an extra $10k per annum.
Very true Bob! I don’t have the time for a small side income right now, but maybe someday.
What an awesome and epic post Mr Tako! I think a hybrid approach makes the perfect sense. That’s why we not only care about our dividend income but the return of our portfolio as well. Obviously your net of safety increases even more if you have some sort of side income during early retirement, so you can rely less on your portfolio… But let’s not get there since I can sense the internet retirement police coming…
I can here the sirens already…. they’re coming for us Bob!
I really like your hybrid approach to cash flow management and investing. It seems like a great hedge for whatever happens in the future. An emergency fund of two years of living expenses in a money market sounds a bit excessive to me though. I guess since I’m still working and in my accumulation phase (with a stable job), I put very little in an emergency fund. But maybe I should reconsider…
Thanks again for a fantastic post.
Well, two years worth might seem excessive, but when was the last time you had a big emergency that was cheap?
Imagine if you had medical issues, needed to buy a new car, the house got damaged in a windstorm, AND the stock market was really in the dumps. That would be expensive and all that could happen because of one big storm.
I’d rather have a little to much than too little.
Ideally, I’d love to lean heavier to income producing assets like real estate. However currently I’m much heavier in assets like stocks. Definitely think having a hybrid approach can create a good balance to hedge against risk. I’m still working on diversification
Diversification is great to a point. At some point it becomes “diworsification” if you spread the jam too thin.
Nice strategy. I currently use my real estate income like dividends and thus focus most of my stock picks without dividend yield as a primary focus. I also don’t plan on quitting work any time soon. Therefore my SWR runs in the negative, I’m still in the accumulation phase. I currently could stop working and live comfortably on 3%. Luckily, I still enjoy my W2 and side hustles.
I have liked Kitces take in the past. He pretty much thought and SWR od 2% is bulletproof for even major economic disaster. Hopefully 3% should do otherwise.
I’ve read his stuff before. We approach the problem from different perspectives but come to pretty similar conclusions.
Thanks for reading Doc G!
Great and thorough article on cash flow. I agree with all points, especially the 2 years of living expenses in emergency fund. That is so prudent, though it’s counter to many fellow FIRE bloggers. I agree with the amount you’re holding. It is so important to have peace of mind!
If I ever wonder if we have enough, I just do a mental repeat of the Great Recession and ask myself how much cash would we have needed to weather that storm.
2 years seems about right.
This is a very well written post. I can’t find much to disagree with here.
My dividend portfolio yield is pretty high at about 3.7% or so, and I suspect this will result in less than optimized capital appreciation although the rate of cash flow growth is quite satisfying. Probably 70% of this is coming from external sources and the internal compounding is only 30% of this number.
I’m much more junior in my investing journey than you and am still finding my stride in investing. It is a lifelong learning experience, isn’t it?
Thanks Mike! I’m constantly learning new stuff!
People are always surprised to hear how much time I spend reading and learning every day. To me, it seems perfectly normal to make time for life-long study.
Fantastic post, Mr. Tako! I really like your approach of balance. Life is rarely black or white and the same holds true for FI cash flow mgmt.
For us, we have a blended approach using both real estate and equities/bonds to facilitate cash flow and growth. Since we’re still relatively young and my wife works, we’re focused more on growth at this point. Yet, there will come a time when we’ll need to flip this equation around.
Yup, at some point (maybe in your 70’s or 80’s) when growth won’t matter much. With any luck you’ll have plenty of assets to make in the next 20-30 years!
Balanced here too. Our dividends cover about 60% of expenses and the other 40% is from draw down. Our target this year is to be at about 2.7%, though of course only about 1.2% is actual draw down.
Wow, nice job Steve! That’s a very low withdrawal rate!
I’d have gone made if I had to wait for 25x to FIRE. I was realistically closer to 10x and planned to maintain a 9-10% withdrawal rate and work part time during market downturns. Actual FIRE expenses proved lower than planned and portfolio growth has been really strong. I’m currently sporting a 4.76% withdrawal rate and I’m very comfortable with that. It amazes me how conservative some people are with their FIRE plans. But gogogogogogo! Your results speak for themselves.
Only thing I would change is to add some pictures of the delicious food you are always making!
Glad to see someone else doing a hybrid approach. This is what we are doing for the most part. I agree with your take on the cash position. Nothing wrong with a safety net in my opinion.