Chapter 4
Freedom and Equilibrium

“There is a better way to do it—find it.”

—Thomas Edison

In his bestselling book Seven Habits of Highly Effective People, Steven Covey urges readers to begin with the end in mind.1 He writes that we first create things in our minds. When you build a home, he points out, you make detailed blueprints before a single nail is hammered. You make sure you've thought through every detail of your dream home before you break ground. I want to think about our finances this way as well. Once you have broken through the initial phases you have a strong foundation in place. From here we can “begin with the end in mind” where we can balance the tri-mandate of enjoying life, paying down debt, and being on track for retirement. Together, we can create a blueprint for your financial goals.

Now that you have made it through the Launch and Independence phases, you are on a balanced path. You have no oppressive debt, a liquid safety net and, possibly, your first home purchased. Now we consider the next steps: Enjoying life and preparing for retirement. In the Freedom and Equilibrium phases we'll work to reduce your debt ratio and build up assets.

Phase 3: Freedom

When your net worth is less than five times your annual income, you simply do not have enough money to retire. During this phase, you want to reduce your debt ratio, save toward retirement, and enjoy life.

I want you to be able to be debt free. If you have these resources and choose to pay off your debts, then good for you. If you understand the potential risks and benefits and embrace a strategic debt philosophy that works both sides of the balance sheet as companies do, then good for you. I want you to be thoughtful and balanced so you can embrace holistic strategies that minimize risk and maximize the probability of a comfortable retirement. I will prove to you that working both sides of the balance sheet and continuing to have debt during this phase will increase your path to financial freedom. First, let's establish the path and the plan.

Early in life and at the end of the Independence phase it's likely your debt ratio is high, potentially over 50 percent. Consider Brandon and Teresa, who we met in Chapter 3. Their debt ratio was 65 percent. Debt ratios above 50 percent depend on income and a lot of things going right. By the time you retire, we want your debt ratio well under 40 percent. So in this phase, we'll focus on reducing it from 65 to 40 percent. This is the next stop on our financial journey; the beacon we can follow on the horizon.

Your debt ratio can decrease by paying down debt or by building up assets. In this phase we want to decrease your debt ratio by building up assets. This creates a stronger base and allows more of your money to take advantage of the power of compounding. And, this puts you on track for retirement. As you start this phase, you have a significant unfunded liability—your retirement—that you need to be saving toward. We want to focus on building up assets more than paying down low-cost, tax-efficient debt.

A Case Study

Let's look back to the end of Independence and revisit Brandon and Teresa. Table 4.1 shows their debt ratio of 65 percent (195,000/300,000).

Table 4.1 Brandon and Teresa Balance Sheet after Home Purchase

Assets Amount Liabilities Amount
Checking account $15,000 Oppressive debt $          0
Savings account $15,000
Retirement investments $30,000
Home $240,000 Mortgage $195,000
Total assets $300,000 Total liabilities $195,000
Net worth $105,000

In nature, balance and ratios are very similar across both large and small objects. For example, the ratios that create the balance in a rose or sunflower has a lot in common with the balance, ratios, and proportions in a hurricane, which has a lot in common with the balance, ratios, and proportions of the Milky Way. The proportions are similar, but the units are different.2 For example, you could measure the Milky Way in centimeters, but that isn't practical. Therefore, as we move to a bigger balance sheet, with different goals, we need to move to different and bigger base units.

The goal of this book is to provide a specific and actionable glide path for the different phases of L.I.F.E. The goal of the first two phases was to build a foundation of assets, which are built from savings, which come from income. In Launch and Independence, the base unit we started with was one month of gross pretax income.

If income was the star and centerpiece of the Launch and Independence phases, debt is the star and centerpiece of Freedom. The goal of the Freedom phase is to reduce your debt ratio. Since reducing debt is the primary goal then we need a different base unit, one that relates specifically to your debt. Therefore, do the following:

  1. Write down your total liabilities (your total outstanding debt) = ________
  2. Divide this number by 8 = ____________

This is your base unit for this phase.

Looking back at Brandon and Teresa, we remember that their only debt is their mortgage. Therefore, Brandon and Teresa would divide 195,000 by 8, which would give them a base unit of 24,375. Now while you may choose to be that precise, I prefer to round it to 24,000. You could also round it to 25,000. Again, think of this as wide channel markers more than hard-and-fast specific formulas.

Why are we dividing by eight? During this phase we are trying to reduce debt as a percentage of the total balance sheet so we start with debt as the target and build around it. The number eight is derived from something called the Fibonacci sequence. More details on this can be found in Appendix A: Phi Phound Me, or if you're curious on the math specifics then I would encourage you to visit valueofdebt.com. If you like the big picture, then stick with me on this formula while we go through the case study and you will see how it comes together.

It is worth noting that this phase is likely to represent 10 to 15 years or more in your life. Typically, income will change considerably for most households during this period. There may be promotions or raises, one person may stay at home, go back to work, and so on. By focusing on debt instead of income we look at how balanced our financial glide path is and discover beacons that can shine independent of the many other changes in life.

Table 4.2 shows where they are today.

Table 4.2 Brandon and Teresa—Phase 3, Freedom

Goal/Bucket Formula A Balanced Path Where You Are Gap
No oppressive debt (No debt at a rate over 10 percent) 0 $ 0 $ 0 $ 0
Cash reserve, checking + savings Base unit × 1 $ 24,000 $ 30,000 $ 6,000
Other (jewelry, cars, furniture) Base unit × 1 $ 24,000 New category
Long-term investments (after-tax) Base unit × 3 $ 72,000 New category
Retirement savings Base unit × 5 $120,000 $ 30,000 –$ 90,000
Total debt (mortgage) Base unit × 8 ($195,000) ($195,000) $0
Net worth Base unit × 13 $317,000 $105,000 –$212,000
Total assets Base unit × 21 $512,000 $300,000 –$212,000

A few things stand out with this table. Notice that cash is a combination of checking and savings in a single bucket. When we combine the two they are a sliver high. We have two new categories: Other and Long-term investments.

The Other category includes personal property such as equity in a car, wedding ring, and furniture in the house. People like to include the value of personal property, but they are of little consequence to our long-term economic analysis, so don't get mired down in this bucket. But if you find you are significantly above the recommended value for this category, I would strongly encourage you to shift your priorities to closing the other gaps.

The Long-term investments category is also new. Generally, people are quick to build up retirement accounts and quick to build up a checking or savings account, but they are missing an investment account comprised of after-tax assets. Starting this account early unleashes a tremendous amount of flexibility with your long-term financial goals, including liquidity and the ability to harness the power of compounding.

In the Independence phase we called this a “big life changes” bucket. We discussed the importance of this bucket being lower risk and that it is a savings bucket for weddings, homes, grad school, and other big life changes. In the Freedom phase, this becomes an Investment bucket—one that you could access if you need to but one that can also afford short-term volatility for the potential of long-term higher returns.

Looking at Brandon and Teresa, you'll notice a massive gap in their retirement and long-term savings buckets. They need to work to fill up these two buckets. Which should they fill up first? A nice split to consider would be 60 percent to retirement savings and 40 percent to long-term investments but they could customize this to anywhere between 30 and 50 percent to long-term investments and the balance to their retirement savings. They should not be focused on paying down their mortgage at this time.

If they follow this road map, their balance sheet could look like Table 4.3.

Table 4.3 Brandon and Teresa Balance Sheet—End of Freedom Phase

Assets Amount Liabilities Amount
Cash $24,000 Oppressive debt $0
Personal/other $24,000
Long-term investments $72,000
Retirement investments $120,000
Home $272,000 Mortgage $195,000
Total assets $512,000 Total liabilities $195,000
Net worth $317,000

Here the debt ratio is $195,000/$512,000 = 38.1 percent. Notice that the debt ratio is falling considerably, even though they have not paid down any debt. This happened because the assets around them have grown more significantly.

To keep this simple, I assume they are on an interest-only mortgage and only made the required interest payment. All other money went to building up assets. To be crystal clear, I am showing their debt ratio falling without paying down anything toward their debt.

With respect to their house, I valued it at $272,000. Their house may or may not have appreciated and, of course, it could have depreciated. It is likely that this phase will take more than 15 years to complete and most people like to assume that houses appreciate over a 10- to 15-year period so I have assumed a modest level of appreciation. If their house appreciates as indicated, their home equity would grow from $45,000 to $77,000, even though they didn't pay down any of their mortgage.

Significant events have now transpired in their financial life:

  1. They have significant assets working for the long term.
  2. They could easily move, change jobs, or survive an emergency.
  3. They have almost $200,000 working for them, plus the home value, which could, over a long period of time, go up in value as well.
  4. If they have a 15-, 20-, or 30-year time horizon, they have increased the chances of a solid retirement.

They have freedom to enjoy life, freedom to change jobs, freedom to do what they want. Money, debt, and finances do not oppress Brandon and Teresa—these things empower them. They liberate them. Brandon and Teresa are making informed, strategic choices. Behind the scenes, they are thinking and acting like a company, implementing some of the most powerful theories in finance, and exhibiting a balanced approach that is found throughout the natural world.3

Application

Use Table 4.4 by doing the following:

  1. Write down your total liabilities (your total outstanding debt) = ________
  2. Divide this number by 8 = ____________

Table 4.4 A Blank Freedom Worksheet—Debt Based

Goal/Bucket Formula A Balanced Path Where You Are Gap
No oppressive debt (No debt at a rate over 10 percent) 0 $0
Cash reserve, checking + savings Base unit × 1
Other (jewelry, cars, furniture) Base unit × 1
Long-term investments (after-tax) Base unit × 3
Retirement savings Base unit × 5
Total debt (mortgage) Base unit × 8
Net worth Base unit × 13
Total assets Base unit × 21

This figure is the base unit to use in completing the table.

As we move forward, it will become increasingly important to be flexible and consider these tables as broad guides. Keep in mind, you can't control the value of your home or the value of your portfolio. These figures will change regularly, so look for the big holes or, if your life is in fairly close balance, look at maintaining the ratios.

Frequently Asked Questions

Continuing to build on our foundation and trying to make the advice as specific as possible, let's address some of the most common questions that come up during this phase:

  • What about student debt?
  • What about income as a base unit? In other words, what if instead of basing the ratios off of debt, how could it be done with income as we did before?
  • What if you don't own a home?
  • How long will this phase take?
  • What about children and children's saving accounts?

What about Student Debt?

Let's say Brandon and Teresa have $30,000 in student debt. If we apply the same framework, it would suggest their base unit is $28,125 ($195,000 mortgage + $30,000 student debt)/8 = $28,125. Our beacons would flash the same signals: de-prioritize paying down debt. Cash is OK. Build up retirement and build up long-term investments.

I would apply the same framework as before. If the after-tax rate is over 8 percent, I would aggressively pay down student debt. If the after-tax rate is between 4 and 8 percent, I would take a balanced approach. I would consider directing 50 percent of your after-tax savings to paying down student debt. For example, if 50 percent of savings goes toward retirement, you could choose to direct 25 percent to building up long-term investments and 25 percent to paying down student debt. If the after-tax rate is under 4 percent, I would not pay any more than you need to for the minimum required payment.

What about Using Income as a Base Unit?

I prefer you use debt as the base unit for this phase. However, if income is your preferred approach, then the table can be created with income as the base by doing the following:

  1. Write down your gross annual pretax household income = ________
  2. Divide the number by 12 = ____________

Use this number as the base when completing Table 4.5.

Table 4.5 A Blank Balanced Path Worksheet—Phase 3: Freedom, Income Based

Goal/Bucket Formula A Balanced Path Where You Are Gap
No oppressive debt (No debt at a rate over 10 percent) 0 $0
Cash reserve, checking + savings Monthly income × 5
Other (jewelry, cars, furniture) Monthly income × 5
Long-term savings (after tax) Monthly income × 15
Retirement savings Monthly income × 25
Total debt (mortgage) Monthly income × 40
Net worth Monthly income × 65
Total assets Monthly income × 105

You can use both ways as a framework for balance and see which areas need to be built up and which need to be reduced. In many cases, these two charts will look similar. In a balanced world, they should be close to equal. If liabilities are out of whack, your debt ratio will fall when you either build up assets or pay down debt. Until you get your net worth built up to more than five times your annual income, paying down debt should be off the table—with the exception of oppressive debt, which you should never have.

What If You Don't Own a Home?

Renting can be great. Depending on the market, you can find considerable value in renting for more of your life, and perhaps all of your life. I'm 41, live in downtown Chicago, and have three kids. There is at least a 50 percent chance I will rent for the next 10 to 20 years, if not the rest of my life. If you are a renter, use Table 4.6 to see how this works when you are in Phase 3.

  1. Write down your gross pretax annual income = ________
  2. Divide this number by 12 = ____________
  3. Multiply this number by 5 = ______________

Table 4.6 A Blank Balanced Path Worksheet—Phase 3: Freedom, No Home/Renting

Goal/Bucket Formula A Balanced Path Where You Are Gap
No oppressive debt (No debt at a rate over 10 percent) 0 $0
Cash reserve, checking + savings Monthly income × 5
Other (jewelry, cars, furniture) Monthly income × 5
Big life changes (savings) Monthly income × 10
Long-term investments (after tax) Monthly income × 15
Retirement investments Monthly income × 25
Net worth Monthly income × 65

Use five months of your gross, pretax earnings as the base unit to look at balance.

How Long Will This Phase Take?

Who knows? My guess is 8 to 15 years, but it depends on so many factors. That is why I focus on debt instead of income. To me, life is a lot like the games Sorry, Monopoly, and Chutes and Ladders—a few steps forward and a few steps backward. The best we can do is control the things we can control. You can control your savings rate. You can control where you direct your savings. You can control your debt ratio. You can't control your rate of return and you can't control the world around you.

Focus on what you can control and be prepared. From my experience, I think it is likely that you may move forward from one phase to another faster than you expected only to step back again, and then forward again, and then back again.

I encourage you to go with it. I think you will be disappointed—and maybe bored—if you approach life as a linear experience. When you are in the Freedom phase and moving toward Equilibrium, you are fully prepared to embrace the journey of life.

What about Children and Children's Savings Accounts?

For many households, children come into the picture during this phase. While children are a great gift, they add more complexity to our prioritization. In addition to wanting to enjoy life, save for the future, and pay down debt, we now also have the added challenge of providing for and possibly sending our children to college. This is another unfunded future obligation. It is another debt to your future self. Here again, the problem is that many people start saving too little, too late, missing out on the benefit and power of the compounding of interest.

The path I'm outlining and the 15 percent savings rate is designed to fulfill the debt to your future self. The good news is, we will see this path has a high probability of success. The bad news is, it doesn't include children. To include children, I would suggest you need to save an additional 2 percent of your income per child from the time they are 6 months old through 22. So if you are saving 15 percent and you have one child, you will need to save 17 percent. If you have two children, you will need to save 19 percent, and so forth. I recognize this is a lot of savings, but if you are willing to make the sacrifice, I will prove it works. If you save less, the trade-off is a few more years of work, which isn't necessarily bad, either. We will do some math later in the book to test and refine this process.

The bottom line theme is the same: Do not pay down your debt during the Freedom phase; build up your savings. For those with children, we are just adding an additional savings bucket, college. While you can do this in a number of different accounts, I recommend that you visit with your advisor about a 529 college savings program.

Phase 4: Equilibrium

Wouldn't it be awesome to have no debt? I think so. What is even more awesome is if you have the ability to pay off all of your debt but choose not to. Instead, you choose to be strategic, thoughtful, and balanced. You take a conservative twist on the strategies used by the largest and most successful companies in the world. You borrow from the greatest theories in finance. You are an empowered, flexible force. Thoughtful. Balanced. On track, and able to change course anytime you want to. You are in control.

In the Freedom phase, we saw your debt ratio can fall by paying down debt or by building up assets. In the Equilibrium phase, your assets are greater than five times your gross annual pretax income. At this point, your biggest debt is still the debt to your future self. You need to build up assets. We continue building up assets more than focusing on paying down debt.

For our base units, we can return to an income-based formula. This is because in the Equilibrium phase you are getting closer to retirement. Retirement is essentially an income-based goal: You want to have an income stream from your portfolio that replaces the income you used to get from working. Even if you choose not to retire, I assume that you would like the option to be able to do so. As with the other chapters, we begin with a case study and then provide a blank guide so you can apply it to your life.

Use Table 4.7 to see where you are in Phase 4.

  1. Write down your gross pretax annual income = ________
  2. Divide this number by 12 = ____________

Table 4.7 Brandon and Teresa Entering Equilibrium

Goal/Bucket Formula A Balanced Path Where You Are Gap
No oppressive debt (No debt at a rate over 10 percent) 0 $ 0 $ 0 $ 0
Approximate cash reserve (checking + savings) Monthly income × 7 $ 35,000 $ 24,000 –$ 11,000
Approximate other (jewelry, cars, furniture) Monthly income × 7 $ 35,000 $ 24,000 –$ 11,000
Approximate mortgage Monthly income × 35 ($175,000) ($195,000) ($ 20,000)
Approximate long-term investments (after tax) Monthly income × 56 $280,000 $ 72,000 –$208,000
Approximate retirement savings Monthly income × 91 $455,000 $120,000 –$335,000
Approximate total investment assets Monthly income × 147 $735,000 $192,000 –$543,000

Always think about this like a ship in a channel of water. The bigger the ship, the wider the channel it navigates. The bigger the balance sheet, the more you want to look at this as a representation of balance but not strict rules to which you are expected to conform. Consider these beacons for which you can aim, not hard rules, which is why I use the word approximate throughout the table.

Recall Brandon and Teresa make $60,000, or $5,000 each month. Let's look at Table 4.7, where they finish the Freedom phase and enter the Equilibrium phase.

Here our beacons are flashing many signals: Brandon and Teresa need to build up a little cash and perhaps reduce their debt, but they also need to build up long-term investments and retirement savings—a lot. The gaps in cash and debt are small. The gaps in investments and retirement savings are large.

Notice the beautiful balance the beacons show us:

  • The debt ratio is $175,000/$735,000, or 23.8 percent.
  • Retirement savings/Total investment assets = $455,000/$735,000, or 62 percent.
  • This is approximately the same ratio of after-tax assets as a percentage of retirement assets ($280,000/$455,000), or 62 percent.

Here again, these ratios represent balance found throughout the natural world, art, and architecture.4 See Appendix A—Phi Phound Me for details on the math, but, big picture, the beacons highlight a clear plan: a declining debt ratio and balance between our assets and our debts.

Let's fast forward several years, and their balance sheet looks like Table 4.8. This shows what their life might look like and compares it to the balanced path.

Table 4.8 Brandon and Teresa—Near Equilibrium

Goal/Bucket Formula A Balanced Path Where They Are Gap
No oppressive debt (No debt at a rate over 10 percent) 0 $ 0 $ 0 $ 0
Cash reserve, checking + savings Monthly income × 7 $ 35,000 $ 30,000 –$ 5,000
Other (jewelry, cars, furniture) Monthly income × 7 $ 35,000 $ 40,000 $ 5,000
Approximate mortgage Monthly income × 35 ($175,000) ($195,000) ($20,000)
After-tax savings Monthly income × 56 $280,000 $300,000 $20,000
Retirement savings Monthly income × 91 $455,000 $460,000 $ 5,000
Total investment assets Monthly income × 147 $735,000 $760,000 $25,000

They are not just on track for retirement, they could potentially retire now. Even better, they can pay off their house if they want; their after-tax savings is greater than their mortgage balance.

Application

Use Table 4.9 to see where you are relative to a balanced path.

Table 4.9 A Blank Equilibrium Worksheet

Goal/Bucket Formula A Balanced Path Where You Are Gap
No oppressive debt (No debt at a rate over 10 percent) 0 $0
Approximate cash reserve (checking + savings) Monthly income × 7
Approximate other (jewelry, cars, furniture) Monthly income × 7
Approximate mortgage Monthly income × 35
Approximate long-term investments (after-tax) Monthly income × 56
Approximate retirement savings Monthly income × 91
Approximate total investment assets Monthly income × 147
  1. Write down your gross pretax annual income = ________
  2. Divide this number by 12 = ____________

Bonus Phase: No Debt!

As your net worth grows beyond 30 times your annual income, our debt journey may be able to come to an end. For example, Brandon and Teresa make $60,000 per year. Once their net worth crosses $1.8 million, they may have a limited need for debt in their life. In fact, depending on your age and time to retirement, when your investment assets cross 15 times your net income, you can carefully evaluate if the risk of debt is a needed risk. For example, when Brandon and Teresa's investment portfolio crosses $900,000, it would be very reasonable for them to just let the portfolio continue to grow and to direct any additional savings to paying down debt.

As we get older and closer to retirement, it is important that we begin to look at our net worth relative to how much money we need on an after-tax basis to cover our expenses in retirement. If you need a rate of return of less than 3 percent from your portfolio, you may not need debt in retirement. For example, you have $1 million and need less than $30,000 per year, or you have $2 million and need less than $60,000 per year. In these cases, debt may not add value. The juice may not be worth the squeeze.

If you need a rate of return between 3 and 6 percent, then a conservative and thoughtful amount of enriching debt will actually reduce taxes, reduce risk, and increase the odds you don't run out of money.9 If you have $1 million and need between $30,000 and $60,000 per year, debt adds value. This was the theme of my book The Value of Debt in Retirement.10

If you need a rate of return of more than 6 percent, then the unfortunate truth is that you need to take risk. For example, if you have $1 million and need more than $60,000 per year from your portfolio, you can either take this risk through asset allocation or you can take it with debt. Faced with risk, I would rather take the least risky risk. Table 4.10 illustrates different distribution rates and the impact of debt on the degree of confidence that you will both run out of money. Here, the goal is to be as high as possible. For example, 100 means that historically there is a 100 percent chance on every tested rolling 30-year period that the strategy did not run out of money. Clearly, past performance does not predict future results, but the message is clear: Depending on your needs, debt can be a very powerful arrow in your quiver to increase the odds that you will not run out of money.

Table 4.10 Trinity Study Summary Table: Probability of Success of Different Distribution Rates over a 30-Year Period—With and Without Debt

Annualized Withdrawal Rate as a % of Initial Portfolio Value
Payout Period 3% 4% 5% 6% 7% 8% 9% 10% 11% 12%
75% Stocks/25% Bonds
Without debt 100 95 69 54 46 41 28 18 3 0
With debt 100 100 87 72 59 54 51 44 41 38
50% Stocks/50% Bonds
Without debt 100 87 56 46 33 15 13 3 3 0
With debt 100 95 77 59 51 46 38 28 23 18
25% Stocks/75% Bonds
Without debt 100 72 31 18 15 13 8 3 0 0
With debt 100 79 54 36 21 15 13 13 10 10

Pay yourself first. The biggest debt you have is to your future self. Don't pay off your low-cost debt until you know you are on track to be able to retire. If you are on track, or ahead of schedule, then you can 100 percent look at paying off your debt.

Congratulations! If you have made it this far, you now know what it takes to be on a glide path that creates balance, peace, stability, and flexibility. But is it better? We have one more step to look at before we determine that. Then we will look at tools to customize your path.12

Endnotes

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