Let’s look at an example of how someone who has high, variable income can manage their cash flow:
Scott, a struggling writer, landed his first major gig with a primetime TV show in the mid-90’s which ended up running for years. He earned over $1 million dollars annually, but he made the same financial mistake almost everyone does when a wealth event suddenly happens–he started buying things. He later thought, “I had no idea what the future would hold, so I thought it would be futile to try and plan for it. I now realize that was the exact moment I should have started planning.”
Unfortunately, this story is all too common among people who have a job that brings in high income, but in an inconsistent time frame.
If you work in an industry that produces big fortunes in small doses (producer, writer, entrepreneur), you may reach a point early in your life where you could start living off your investment portfolio long before the word “retirement” even crosses your mind.
The High-Income-Low-Saving Years
While there’s nothing wrong with enjoying a big payday and boosting one’s lifestyle (million-dollar house, expensive vacations), Scott never considered how much cash he might need when his job eventually ended. He only saved to a retirement account (essentially off-limits until a person turns 59 ½). When his show ended in the early 2000s, he’d built up a modest amount of assets. But he had no idea when his next show would begin, or how much the new show would pay him.
Scott was lucky and eventually got his next dream job. Now in his 40s, Scott’s been working on a show that produces an income far-exceeding his basic needs. He loves the idea of building his nest egg to a level that will provide a stable, recurring income stream before he turns 50. While he wants to be able to splurge a bit while he’s earning at the high end of his capacity, he’s also feeling it’s time to set some limits and prepare for the future.
Making A Plan
It’s time for Scott to reflect on what a “minimum lifestyle” means to him (i.e. the lowest amount he’s willing to spend each year). This will tell him what his nest egg needs to grow to in order for him to support that lifestyle. He plans to use a 3% spending rule–meaning, once his annual spending need is lower than 3% of his nest egg balance, he can start taking recurring withdrawals. Scott estimates he’ll need $100,000 per year to cover his basic needs, so his portfolio needs to grow to at least $3.3 million before he can implement this. If he can achieve that, Scott will work for as long as he wishes and then use that extra income to enhance his life in any way he desires.
A quick, semi-nerdy word about retirement: Traditionally, when preparing for retirement, you reach your 60s, multiply your nest egg by 4%, then use that number as your spending allowance for the rest of your life.
Have $2 million at 65? You could withdraw roughly $80,000 annually in perpetuity, plus annual cost of living adjustments. If you don’t panic during a market correction by moving your portfolio to cash, the odds are you’ll still have some money in your nest egg at 100.
However, if you want to use your portfolio to cover basic living needs before you turn 50, we suggest dropping that 4% rule down to 3%. Why? In Scott’s case, most of his withdrawals will be made with actual portfolio income (dividends from stocks and interest from bonds). Since a very small portion of his cash flow needs will come from appreciation, his portfolio should have no trouble maintaining its value over the long-term, even after factoring inflation. While the 4% rule relates to how long a person will need their nest egg to survive, the 3% rule doesn’t.
Finding Your Minimum Lifestyle Number
Scott estimates he can live comfortably in Los Angeles with $100,000 of annual cash flow. To support this number, he’ll need his nest egg to be just over $3.3 million in today’s dollars. Now, the tricky part. He wants to get there quickly, but he also has a couple of big-ticket purchases he’d like to make in the near future, such as a nicer home and the ability to pay for his kids’ college. He also faces an unknown income situation in two years when his show ends. To help reach his goals, we’ve recommend the Spend-One-Save-Two Rule.
In this system, Scott is permitted to spend up to 1/3 of his take-home pay in a given year. If it’s $500,000, then he could spend up to $165,000. But since Scott wants to reach his nest egg goal quickly, he’s going to lock on his minimum-spending figure of $100,000 regardless of how well he does.
Save 1/3 To A Vault
Scott will save 1/3 of his take-home pay (whatever the amount) to a long-term bucket that we’ll call the “vault.” This money is considered off-limits until his nest egg reaches the point where he can support his minimum lifestyle. To make it even harder to touch (as well as enjoy more tax benefits), he’ll put as much of this money possible into retirement accounts, such as defined benefit plans and 401ks.
Save 1/3 To A Liquid Bucket
After saving to the vault, any surplus take-home pay will be invested, but Scott will also have the option of making withdrawals should the need arise. If he had a period of low (or no) earnings, he could take money out to meet his minimum lifestyle requirements. This is one reason why people in the entertainment field should keep a larger “emergency fund” of cash in the bank–perhaps as much as a year’s worth of expenses–and then invest anything beyond that. Scott has a few years’ worth of expenses in this account, so he’s already prepared in case there’s a few dry years. He can also save money to this bucket for his shorter-term goals like buying a bigger house or funding his kids’ future college needs.
The Big Caveat
Normally, Abacus supports the use of “good debt,” such as a school loan or house mortgage, unless it’s for someone with an unpredictable income like Scott. Why? Because if he makes a big purchase that’s accompanied by new recurring costs, the whole plan can fall apart.
Imagine if Scott upgraded to a much fancier house. This would come with higher property taxes, repair costs, and insurance premiums (just to name a few), causing his “minimum lifestyle” figure to rise. If his income suddenly drops by a large sum for an extended period, he might be forced to sell the house suddenly and fast. This would not only be stressful, but may result in having to accept a lower price than what a seller would normally get when they have time to hold out for the best offer.
Cash might very well be king for people with unpredictable income. If Scott wants to upgrade his lifestyle, and home ownership is important to him, he should wait until his liquid bucket is large enough to buy a house with cash. This would keep his out-of-pocket housing costs close to where they are today (property taxes, insurance, repairs, and more will still obviously require some planning). Even better, Scott might consider maintaining his status as a wealthy renter for maximum portability, at least until he’s built up his nest egg.
The Spend-One-Save-Two system only works because Scott already has some liquid reserves built up and is expecting additional years of high income. Hopefully this will allow Scott to enjoy his successes a bit more when they happen but feel more prepared for the quiet periods. He’ll take this process one year at a time instead of simply trying to guess what this all means for his “retirement” years. For now, he knows exactly what his nest egg needs to grow into for him to live comfortably in an expensive city. For a guy in an industry filled with excitement and stress, he now has one less thing to worry about.Do you have a high variable income with questions about retirement? Contact an Abacus advisor today to help build your future.