Before diving deeper into this crazy concept, I think I should first take a step back and explain how I got here. Once I’ve laid down a basic narrative of my logic, then we can start looking at practical demonstrations of how this theory works.
A few months ago, I came across a video that talked about the Norwegian Sovereign Wealth Fund, which is this fund set up by the Norwegian government from all the oil drilling license revenue it’s been receiving for the past half century. I’ll explain it further in a later post, but what is important about this fund is it’s now worth over $1 Trillion and they can take up to 3% of the fund’s value to be applied to the federal budget. This has allowed Norway to maintain high level programs for its citizens without having to raise taxes in order to compensate for them.
The perpetual aspect of its use captivated my attention as I sought out other ways this concept could be applied. Even though this function works much like how endowments work, I realized what I was seeing behind all this was how multi-functional funds can be; Instead of putting money aside for many years and then reaching a point where you stop contributing and start withdrawing, why can’t the fund provide active funds today meanwhile you contribute for the long-term?
The goal of endowment funds and nest-egg investments is to accumulate a large enough balance that allows you withdraw less than its growth rate, which allows for funding in perpetuity. But why can’t you start that process during the contribution process so that you are provided with funds today, while you’re also feeding back into the system more over time to replenish the fund? You start creating this positive-reinforcing cycle where your consumption transitions from inflow (wages/donations) that you have to keep replenishing every year, to now coming from returns that are continually growing.
To give an analogy, this concept is like eating an apple: you can eat the fruit and the seeds for sustenance (yes, you can eat the seeds, it’s only poisonous if you eat like, 20 apples worth of seeds in one sitting), but then in order to eat another apple, you have to buy another apple in order to consume it, and this process repeats itself over and over again. But what if you just ate the fruit aspect of the apple and then planted the seeds in the ground. It may take a little bit of time, and if you want another apple next week, you’ll still have to acquire another apple, but next year, that seed will grow into an apple tree that provides more apples. This is still real basic, but the idea is that on this grown tree, you consume now from that investment early on, and you continue to do that, so you take the seeds from the apples you consume from the tree and that produces more trees the following year. Once this process continues, you no longer are having to go buy apples, but you’re just consuming from apple trees that were planted years ago.
Where these thoughts took me to initially was to non-profit funding, where we can take a small slice of donations placed into an endowment fund that slowly gains momentum over time to the point that the returns on the endowment could exceed projected donations and not only provide a perpetual source of funding, but also provides a large cash balance that assures the longevity of the organization. I’ll explain that further in a later post, but after building a spreadsheet on that concept, I started exploring how this concept applies to personal finance, and that is what I’ll be focusing on here.
So let’s finally now see how this concept actually works: Let’s lay out a hypothetical scenario where we have a $50k annual salary over the next 30 years, and let’s also assume for simplicity sake that we’re able to generate consist 10% investment growth annually. What we do then is we’ll start off investing 10% of our income, which is a total of $5,000 in that first year ($416/mo). At the end of the year, we got to live on $45k and our $5k investment gained $279 so is now worth $5,279. But at the beginning of year 2, we cash out 5% of the account balance, which is $263. It’s basically like an early tax return, and the investment account is now worth $5,016. But we’re also now going to up our investing percentage by 2% additional percent, so we’ll now invest $6,000 in year 2. This means in year 2, we’ll be able to spend $44k plus the $263. At the end of year 2, the account is now worth $11,875.
It’s a lot of numbers being thrown around, I know, and if it helps, you can pull up the Google Sheet I’ve made. This whole example comes from the Static Income sheet, so you can follow this example here, and track the changes along the sheet as well:
Let’s now jump ahead to year 5: At the beginning of the year, the investment account is now worth over $40k and that means that you now get to start the year with $1,400, while over the year you’ll now put in another $9k. This means you’ll be living on slightly less than you were 5 years ago, with $41k in wages, but you’re also getting an additional $1,400 to start the year off with.
The best part is that this is basically as much of a budget crunch that you’ll ever experience, since over the next 10 years, the overall amount you live on doesn’t ever drop below $41k. But during this time, something powerful is happening that may not be readily apparent.
YEAR 15: The Turning Point
Let’s now look at year 15: This year you get to start off with a cash balance of $11k! Think about that, if you’re making $4,166 per month in wages, that means you get the first 2.5 months of wages up front essentially. How much of a relief would that be to have $11k in the bank? Wouldn’t that make it even easier to invest?
I want to pause right here and explain the significance of this. For most of us, our biggest financial constraint isn’t actually how much we make, but when we receive it. Payday lenders stay relevant not because people don’t make enough money, but because they have to pay rent today, and their paycheck comes next Friday. We carry credit card balances that incur interest because we’re always one step behind, but what if we had access to all the money we made this year today? Or what about trying to buy a house? Again it isn’t that we don’t make enough money, since we’re already paying rent which is usually similar to mortgage payments, but for most people, we continue to rent because we can’t gather up all our cash together to make that initial down payment; we have to be diligent over time to take what is left over after rent and other expenses to build up the cash for that down payment. Having $11k front loads your wage earning to the beginning of the year which allows you to use your income more effectively.
What this is also doing is it’s slowly transitioning you away from your dependence on wages and onto financial returns, but not completely. At year 15, you’ll be on track to investing 38% of your wages towards investing, but that still means that you take home $2,583 per month. Even though before doing any investing you were taking home $4,166 per month, it’s not as important now since you have $11k in the bank, so you now don’t even notice that $1,583 that is going towards investing that month.
By receiving that front-loaded cash out, it is also removing the salient cost of investing, which then creates a positive-reinforcing mechanism that the more you invest, the more of a lump sum you get the next year, which just makes it easier to invest more money. This is another vital aspect of this model is that the positive feedback from investing makes every step easier to make, rather than harder. For many of us, long-term investing is extremely difficult since we don’t see any of the returns for many years down the road, and we have needs presently that the investment could be used for. Even if we’re diligent for a few years, and accumulate a modest sum, the constraints of life make it even more tempting to cash out all our funds that kills all the momentum. This model taps into that, but in a constructive way that provides for present needs, but without erasing the growth foundation.
But let’s now return to year 15. We start the year off with $11k, and we’re going to invest 38% of our income, so that means we’ll be taking home $31k in wages, but we’re also getting that $11k upfront, making the total income at $42k. But what about the investment balance? It’s now over $250k! That’s right, you were able to cash out $11k, and still you’re going to end the year with a quarter-million dollars in investing in just 15 years.
By restructuring our revenue stream, we not only are able to have more efficient income that creates a buffer for short-term financial shocks, and makes us more financially resilient, but that resilience also feeds into long-term growth as well.
YEAR 30: Millionaire Status, plus benefits.
Let’s now jump to the end, and see what year 30 looks like. Again we’re assuming no promotions or pay raises, and we’re averaging 10% growth annually. For year 30, we start the year off with $51k! That’s right, we are now receiving beyond what we are even planning on making that year in wages all up front to begin the year. We get all 12 months of paychecks up front, with a bonus $1,295 on top of that! If year 15 was providing positive reinforcing feedback on investing, how much easier is it now for you to invest more money if all you expect to earn is given to you right at the beginning?
But it gets even better; we set up the model to increase investments by 2% annually, so at year 30, we’re only planning on investing 68% of our wages, which means that we’re going to get an additional $1.3k per month to take home from wages, bumping our annual income of $16k in wages plus $51k in returns to a total of $67k. That means we are going to live on 134% of our wages, even after we already invested $34k! We are almost literally getting paid to invest at this point; investing money is no longer a cost that impacts your life, but is actually providing you a better standard of living before you have even retired!
Speaking of retirement, how much is the investment balance at the end of year 30? How about $1.1 Million! You are a millionaire just from your investment portfolio and you are also cashing out parts of it, and it still grew by over 100k in value that year.
I know that is a lot of information, and even with this demonstration, it may still be quite confusing. Don’t let that confusion scare you away: it’s not that you lack the understanding, but rather it’s just a complex concept. But don’t worry, I’ll continue to break this down into finer parts so that the logic can be better understood in the following posts.