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THE LONG VIEW

Financial freedom is just $4.5-million away Add to ...

Let’s put a price on freedom.

Many of us dream of being able to walk away from work, supporting ourselves solely on income from our investment portfolios.

But what does that fantasy really mean?

The ideal arrangement would be to take as little risk as possible. We would live on only dividends and bond yields, without ever touching our capital.

To be sure, this dream could quickly turn into a nightmare if it required us to live on a pittance. Most of us would stipulate that we want at least as much annual income as the median Canadian family.

Given all that, what would freedom cost? Roughly $4.5-million, according to my calculations for the – drum roll, please – first ever Financial Independence Index.

The index is a toy I’ve developed to answer the many readers who want to know when they can say good-bye to work without ever having to think about money again.

The good news – and you may be happy to hear this – is that the index is not designed as a realistic savings target for most families.

Think of it instead as an indicator of how financial conditions have shifted over the years – and also as a demonstration of why most of us have to keep thinking about money and risk, even after we quit work.

The Financial Freedom Index owes a great debt to Scott Burns, a pioneer of personal finance journalism during his years at the Dallas Morning News. For years, he’s compiled the Life of Riley Index, which puts a price tag on financial freedom for Americans.

I’ve adapted Mr. Burns’s approach for the Financial Independence Index. Like the Life of Riley Index, my version assumes you keep half your money in stocks, half in safe government bonds.

But while Mr. Burns uses U.S. figures, my model is based on Canadian markets and on the median after-tax income of Canadian families. I’ve adjusted the figures from Statistics Canada to compensate for the impact of inflation. I’ve also assumed that a couple who are living off dividends and interest will have an income tax rate of only 10 per cent, given the tax efficiency of dividends and the potential for income splitting.

My adjustments suggest that a median Canadian family in 2015 has about $74,000 in annual after-tax income. I figure to generate that same income in a portfolio split evenly between Canadian stocks and Canadian five-year government bonds, you would need just under $4.5-million.

This assumes you are merely reaping dividends (at the 2.78 per cent yield of the S&P/TSX Composite) and clipping bond coupons (at the 0.84 per cent yield now prevailing on the five-year Government of Canada bond).

Hopelessly conservative, some might say. But the point here isn’t to recommend an investing strategy. Instead, the goal is to put a price tag on what it would cost to be truly free of financial worries – to have so much money that you don’t have to worry about market crashes, defaults, currency disruptions or most other nasty stuff short of a revolution.

The price of such freedom has varied a lot over the years. Twenty years ago, for example, the dividend yield on Canadian stocks was only 1.44 per cent, about half what it is now. But yields on five-year government bonds were much, much higher – around 7.5 per cent – and median family incomes were lower.

As a result, a mere $1.4-million would have bought you financial freedom – and that’s in today’s dollars, not the 1995 version.

The size of that shift is remarkable: The price of financial freedom has more than tripled, in real terms, over the past two decades.

The soaring cost of financial freedom reflects, in large part, the long slide of bond yields. Once the bulwark of many income portfolios, bonds now offer next to no payoff.

You can derive more income these days by investing in stocks. Indeed, a stock-only portfolio would cut the cost of financial freedom to a bit more than $2.9-million. But a stock-only approach leaves you vulnerable to dividend cuts, as well as big swings in your portfolio value.

As the Financial Independence Index makes clear, there is no cheap route to freedom. In fact, it’s rarely, if ever, been more expensive to be considered rich. Those of us who fall short can at least take heart in that.

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Follow on Twitter: @IanMcGugan

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