There is a phrase I frequently read and hear from financial independence types that I find extremely confusing, and which is one of many reasons I find the concept of financial independence troubling, at least as I’ve seen it promoted on the internet. The phrase is: “depending on what the markets do.”
A typical formulation is, “we’ll be financially independent in 2018, depending on what the markets do.” Or: “I’ll quit my job in February, depending on what the markets do.”
This is the corollary of the “4% rule” (or the 3% rule, or the 5% rule), which suggests that you can calculate the market value of assets needed to retire by dividing your needed income by some predetermined percentage.
Only one of two things can be true: you can become financially independent based on the market value of your assets, in which case you can likewise become newly financially dependent based on the market value of your assets. Alternately, if you are still financially independent when your assets decline in price, then you were already financially independent when your assets passed through those new, lower prices, and you were wrong to rely on the safe withdrawal rate — you should have been using some other, better metric.
My personal guess is that faith in these “safe withdrawal” models is based on the fact that most financial independence types have been pursuing early retirement only in the aftermath of the global financial crisis, and thus have only limited experience with large, sustained collapses in prices across approximately all asset classes. The belief that US equities will rise by 8% per year in perpetuity seems, if anything, conservative given the sustained run stocks have been on since 2009.
But economies enter recessions, asset prices fall, and when they do I think the knock-on effects are going to be devastating to many early retirees.
Let’s talk about correlation
For example, Coach Carson describes a technique he calls “house hacking” in the following way:
“Once I had 3 of the 4 units rented out, I moved into the 4th unit, lived there for 6 months, and applied for a refinance. Because the value was now much higher (about $155,000), I was able to borrow $120,000 and pull out 100% of my invested money. This particular strategy is known in online real estate circles as the BRRRR Strategy (Buy, Rehab, Rent, Refinance, Repeat). But I’ll talk about that more in the financing section of this guide.”
What has Coach Carson done here? First he creates an asset (the property) and a liability (a bank loan and “private financing”). Then he spends some money improving the property. Then he creates 3 new assets (3 contracts with tenants to pay him) and 3 new liabilities (3 contracts with tenants to provide them with housing). Then he creates a new liability using the increased value of the property as collateral, and a new asset, the cash in his bank account.
At this point Coach Carson is probably ok. Even if all 3 of his tenants broke their leases tomorrow, he’s still got $120,000 in his bank account, which could presumably service his mortgage, private financing, and line of credit for years. Hell, if he wanted to he could just abscond with the money and leave his creditors holding the bag.
But Coach Carson isn’t going to sit on $120,000 forever. He’s going to invest it, and therein lies the problem. When the crash comes, his assets will halve in liquidation value, but his liabilities will remain unchanged. Even worse, his tenants will lose their jobs, break their leases, and move back home. Coach Carson is going to have a hard time replacing them, and will be forced to accept lower rents — if he’s able to find new tenants at all. Suddenly his cash-flow-positive or -neutral asset has become a cash-flow negative asset, forcing him to find more and more money elsewhere — like his recently cratered stocks. Coach Carson no doubt thinks he’s going to go on a buying spree when he can get stocks at a deep discount to their current prices. Instead, he’s going to be liquidating them at fire sale prices.
Ok, I don’t know anything about Coach Carson, and this has nothing to do with him personally. But what he is describing clearly has nothing to do with financial independence.
What is your model for financial independence?
Many financial independence types have gotten into the content game lately, and good for them — the more the merrier! But the basic pattern I described above applies with minor adjustments to this business model as well. When the economy next stumbles and people start canceling their Blue Apron subscriptions, who is going to pay for weekly podcast ad spots? When venture capital dries up, are the warring mail-order mattress companies still going to be around to dole out sales commissions? When credit tightens and defaults rise, are banks going to be paying anyone who asks nicely for credit card referrals?
In other words, the part-time job you’re counting on to insulate you from the vagaries of the market cannot perform that function if it is also subject to market forces. “I can always drive for Uber” won’t work when Uber collapses amidst lawsuits from creditors and employees.
Dependence is the natural state of man
I’ve been referring to “financial” independence as a nod to the genre, but if you widen the aperture just slightly you can see that financial independence isn’t impossible due to some nuance of double-entry bookkeeping, it’s impossible because independence is impossible.
It makes as much sense to talk about financial independence as it does to talk about medical independence. Even a surgeon with the skill and confidence to perform surgery on herself (awake!) doesn’t know how to compound the anesthetics and antibiotics needed to survive the procedure: she’s medically dependent on a pharmacist.
A stable and growing economy is full of exciting opportunities, and I am a fierce advocate for people to seek out and explore those opportunities rather than rotting in a cubicle (although if you are rotting in a cubicle I hope you follow me on Twitter to stay distracted). But to live in a stable and growing economy we’re dependent on good macroeconomic policy from policymakers we individually have little influence on. We depend on the quality of our representatives and, for their selection and election, on our fellow citizens.
None of this has anything to do with work
I’m a great believer in early retirement — so much so that I retired at 28. But I am not, and have no intention of ever being, financially independent. I depend on the Affordable Care Act to provide affordable, comprehensive health insurance. I depend on the courts to protect me from being wrongfully evicted. I depend on water utilities to provide access to potable water. I depend on Google to accurately track visitors and pay me my share of their ad revenue. On my other site, I depend on Stripe to collect and distribute readers’ subscription payments. I depend on the Automated Clearing House to deposit the payments in my bank account. I depend on elected officials to defend Social Security so in old age I’ll have a guaranteed source of inflation-protected income.
In other words, I’m as dependent as a newborn child, and always will be. If you’re waiting to retire until you’re financially independent, you’re going to be waiting a long, long time.
I disagree with your assertion that you have “retired” at age 28. Writing is still work, just as much as Mr. Mustache continues to write and earn revenue from affiliates. Yes, you’ve left the “conventional workforce” but I would argue the very nature of the USA is that we don’t just rely on conventional jobs. So, again, I don’t see how you are retired.
Trevor,
I spend all day walking around, reading, thinking, and writing. I sure FEEL retired. How will I know when I really AM retired? Should I start playing golf, too? Or maybe shuffleboard, that’s a good retiree game…now this idea is starting to grow on me…
—Indy
Ah, the ol’ not paying your fair share game. Retired at 28, counting on others to fund your heavily subsidized Healthcare. But hey gimme another rant on how the guy making 400k a yr isnt paying “his fair share”. I love it.
SumOfAll,
I just checked to be sure, and I have never used the phrase “fair share.” I suspect you’re thinking of a different site.
—Indy
Some has to kick in your share of the actual healthcare cost to get you the affordable comprehensive health insurance. Can we at least agree someone elses taxes (making 250k+) is paying your share of the subsidy? So when you ask for reasonably priced insurance arent you really asking for someone else to pay for yours?
SumOfAll,
Two quick thoughts. Health insurance is a particularly bad example of what you’re describing because the addition of young healthy people to an insurance risk pool lowers the rates charged to everyone in the pool. In that way just knowing someone makes $250k per year doesn’t provide enough information to know whether he’s subsidizing me or I’m subsidizing him. Since I don’t use the healthcare system I’m one of the people dragging down premiums, while he might be a high-cost enrollee who is dragging up the premiums. It’s true that a poor, sick person could also have higher healthcare costs than a rich, healthy person, but that’s just describing the nature of health insurance in a particularly pedantic way.
Second, while there are no doubt specific situations where the cross-subsidy you’re describing does apply, I actually think they’re less common than anti-tax zealots suggest. For example, I mentioned being glad to have housing courts I could rely on to protect me from predatory landlords, and indeed the wealthy are also free to take advantage of such courts. But the wealthy also are able to take advantage of Delaware Chancery Courts to protect the rights of their LLC’s, which I have no intention of ever using. So if you are so inclined to “assign” the taxes paid by higher-income individuals to particular expenditures, often those taxes are properly assigned not to subsidizing public services for lower-income folks but rather to government operations that benefit the very same high-income taxpayers — there’s no cross-subsidy at all. A classic example might be police protection: since the wealthy, by definition, have more to lose from crime, they would finance a police force to protect them no matter what. The addition of whatever taxes lower-income folks are able to pay reduces the amount the wealthy are forced to contribute for police protection.
I think there are many more situations like this than situations in which the cross-subsidy you suggest applies.
—Indy
I dont think low income earners pay any substantial amount of taxes (but definition). As for healthcare and taxes there is that nasty 3.8% investment tax levied specifically for the subsidized healthcare premiums
But you’re still doing work – it is work to write for example. Otherwise one could argue that if you love what you do, you’ll never work a day in your life, and thus are retired, but it contradicts the definition of retired: “having left one’s job and ceased to work.”
I really appreciate this post, thank you for sharing it! “Dependence is the natural state of man” – such a very uncomfortable truth.
The idea of dependence is uncomfortable in our individualistic culture; however it is the natural state of nature and man. It is nice to be dependent on family, gardens growing, , friends for coffee, but the reality of the distorted culture we are in is the primacy of things like real estate markets, stocks, corporate BS.
Clearly late to this, but it is an excellent post indeed, especially the 2nd half of it. I think it nicely shows why libertarians are idiots, and sums how i perceive the world and consequently why I identify with the left politically. No one individually could even make a pencil without takes months and months to do so, we are so reliant on society as a whole to work smoothly for our own life’s to work too. Great post.