FIRE part two: Generating cashflow
Reading time: 4 mins
So, now we understand what the FIRE movement stands for and why there is a growing community following it we are now going to consider the first of the three components of the Financial Independence equation: the different ways we can generate income.
Aside from pure luck or privilege like receiving an inheritance, benefitting from a trust fund or winning the lottery the vast majority of people are born into a situation where they will have to earn their own income. Most of your dreams and aspirations tend to require the fuel of money to get realised and so it is incumbent upon us to leverage our time, talents and efforts towards optimising the money acquisition game. In time honoured management consulting tradition we are going to consider the different income generation routes through the lens of a two by two matrix.
What is FIRE exactly?
Trading time for money
If you haven’t read the cashflow quadrant by Robert Kiyosaki then I highly encourage you to do so as this provides a simple breakdown on the available methods of earning your cash. We are going to lean on his four quadrants template as a way of breaking down the pros and cons of each income stream.
The top left hand box refers to the most common way that people earn their money and that is as an employee. The reason why most of us work as employees is because this is how the system has been designed. The demands of the industrial revolution required that we mass-produce employees who could work in and run factories and other labour intensive occupations. Even the shift to the knowledge economy from the late 1970’s onwards still requires the same type of university-educated automaton that is taught mainly to do and not so much to think.
That being said there are a number of benefits associated with being an employee and the first of those is security, not necessarily in the job security sense (although that is very real in some European countries like France and the Nordics) but it is more about the security of a steady income and steady benefits. These benefits are usually associated with the provision of private healthcare (particularly important in the US) and a private pension plan (known as a 401k in the US) where your company will normally match or provide a multiple of your own contributions to the plan. The other main advantage of steady income comes from the fact that it allows you to plan and manage your household and personal finances because you always know how much money you will receive at the end of the month. If we consider the cons associated with being an employee the chief cause of angst for most people is the lack of perceived control that you have over your situation. You are effectively a slave to your wage and the company hoping that at the end of each year your boss will grant you at least a 2% increase just to keep you in line with inflation. Secondly, you are time bound to your job – you are trading your time for money and if you work a professional job in a place like London or New York that can mean anywhere up to 80 hours a week. And that doesn’t include your daily commute time to and from the office either! So if at any point you decide you don’t agree with trading your time for money then effectively your income goes down to zero and your stress level goes to nuclear. Finally, you also have the highest taxes to pay as an employee compared to any other form of earning income as you have no way of sheltering or hiding your money from the taxman because it is deducted at source.
According to the old adage there are only two guarantees in life and that is death and taxes. The question you should be asking yourself though is how much tax should I be paying?
Moving on to the lower left box we consider the pros and cons of being self-employed. Intuitively many people think that being self-employed would be more preferable than being an employee however as we shall see there are hidden drawbacks that you may not always expect. There is a common perception of increased freedom when compared to having a regular employee job. However, this has to be balanced against the fact that you have instead created a job for yourself and not yet a separate functioning big business. Yes, your job is a business for you but at the moment you are the still the head chef and chief bottle washer. You are not able to leverage your time as would be expected from a developed business. This brings us onto one of the chief cons of being self employed as even though you are your own boss the business lives and dies on your effort so this means you will often be working far more hours than if you did the equivalent job as part of an organisation. Until you have built scale then you are not running a business in the true sense of the word – you are operating as a soletrader. You are also now responsible for administering your own tax situation and whilst in practice this means you should become more tax efficient than a regular employee complicated tax structures can often add ambiguity and additional cost. For a UK citizen for example there are decisions to make around the tax advantages of operating as a soletrader v incorporating as a limited company, which bracket of national insurance contributions to contribute to, if at all, and setting up and contributing to your own personal pension and own private healthcare. Don’t forget also that you are not getting paid for any weekends and holidays either so that is dead time which dilutes total personal income when compared to a salaried employee. You also introduce a higher degree of uncertainty around your ability to forecast earnings as you are subject to demand/supply constraints and the level of perceived market value that you can generate for yourself.
Time is the common factor between these two quadrants. To be more precise they both require time to make money and then even more time to continue to preserve the inflow of that money. The moment you decide that you no longer wish to devote as much of your time to the cause you immediately sacrifice your earnings potential.
The top right quadrant considers the benefit of building and running a business or a situation where you have now achieved scale. Lets consider the example of a plumbing business. Originally you were once a plumber working for someone else’s business – you were a salaried employee with all the pros and cons as listed above. Then one day you decided to become a self employed plumber and you put in considerable time and effort to try and build a pipeline of business for yourself often suffering from burnout and uncertainty along the way and trading even more of your time to keep financially afloat. Over time you were finally able to scale your efforts into a situation where you have sufficient business inflows that you could employ other people to do the plumbing jobs for you and operational managers to manage those people and run the day to day operations. This is the first and most clear benefit to growing your own business – you are able to leverage your time so that other people are doing the majority of the day-to-day operations and income generation for you. The next advantage of building a business and operating as a limited liability company comes from the tax efficiencies you can take advantage of in the way you manage your business expenses, employee salaries and indeed your own re-numeration. Without going into deep accountancy detail here (perhaps a separate post can cover this topic) you are able to offset a lot of expenses as company expenses (company car, company travel, company furniture and fittings) as well as employee costs (salaries, pensions, healthcare etc) from pre-tax income thus reducing your tax bill on overall company profits. You are also able to pay yourself as a director in the company through a combination of salary and dividend payments so that you can take advantage of more favourable tax rates when compared to being either a salaried employee or a self-employed sole trader.
The benefits of achieving time leverage and tax advantages by building and scaling your own business when compared to the first two quadrants are clear; you are creating freedom, both financial and personal, to explore and develop further projects and interests. You are also escaping the short-term tyranny of having to constantly worry about earning money though in the case of building and leading a business that is not to discount the hard work and effort to get there in the first place along with the stress of maintaining what you have built.
All of the above leads us nicely into my favourite quadrant and it should be yours too if you want to know the truth about getting rich. This is where people make money. They are no longer trading their time for money instead they are taking the money they generate from their business and they are investing it so that it in turn works harder for them. The goal here is to make money your employee a not to be an employee to your money. Thus the single greatest benefit that comes from participating in the investor quadrant is your ability to drive exponential returns on capital invested and in so doing to develop the passive income streams that will safeguard your financial prosperity. It is important to note that becoming an investor is risky and many an amateur investor has been caught out by the market or has suffered the ignominy of poorly received wisdom. One would hope that if you have already passed through the first three quadrants then by the time you are investing in a serious way you will have developed a solid appreciation for the numbers. There are also numerous tax thresholds and implications to be considered when investing; be they capital gains tax, dividend tax, stamp duty etc however the key point to note is that all of these implications are still more efficient than if you are paying top rate taxes as either an employee or a self employed individual.
This concludes our overview of the different methods of generating income. I hope you will see the contrast between the trading of time for money in the first two quadrants compared to the benefits of leveraging your time and having your money work for you in the second two quadrants. The difference, essentially, is between achieving actual financial independence versus the illusion of a progress towards it. This is not an easy path to forge and as we shall see in future articles it requires a dramatic shift in behaviours and attitudes in order to re-position yourself towards developing a sustainable financial future.
Leveraging time and money