Lesson 5: Critical Capital™

For most people, Financial Freedom is a vague dream lacking definition. Unable to face the reality of what it takes to create financial freedom, they float toward retirement hoping, "everything will work out." Some will make it, some won't. Your stock options may be the key to your being among those who make it. But without defining what's required to reach financial freedom, specifying how much is "enough", you risk losing that opportunity by making your decisions based solely on minimizing taxes or "making the most." The key to achieving financial freedom is focusing on something we call Critical Capital™: The amount of capital you need to pay all the critical expenses you will incur for the rest of your life.

Once you define your Critical Capital™, and what it will take to reach it, the decisions you make regarding your stock options will become much clearer and easier to make. This lesson will introduce you to the key variables necessary to define Critical Capital™ and serve as a foundation for the Strategy section which will explain how to best use your options to create and protect your Critical Capital™.

What Does It Take To Reach Critical Capital™?

If you happen to be one of those lucky stock option owners who have scored big time during this bull market, you might have already reached Critical Capital™ without even knowing it! If so, you may actually be risking your financial freedom, if you're not taking prudent steps to protect your Critical Capital™.

But for most people, even those who have significant, but not seismic option grants, reaching Critical Capital™ is a long term process. Above all, getting there requires patience and discipline. This doesn't mean you can't have fun and live a full life along the way. It means you need to maintain a constant awareness of what your Critical Capital™ is and how your financial decisions will affect your creating and then protecting it.

How Do You Calculate Critical Capital™?

If life and our financial world were simple, calculating your Critical Capital™ would be simple. All you would have to do is identify all your expenses, decide how long you are going to live, and then calculate how much capital you need to pay those expenses. For example, if your expenses would be $5,000 per month for the rest of your life and you will live 30 years, your Critical Capital™ would be $1,800,000 ($5,000 x 12 x 30).

But life's not quite that simple, is it? Your expenses may not be level and may include one time or periodic expenses like the purchase of a home, college for your children, the purchase of cars, etc. They are also likely to increase in the future with inflation. Some may change with your employment. For example, your employer may be paying for health insurance or a car that you would have to pay for if you stopped working. Your clothing and entertainment expenses might change if you no longer need to entertain clients.

You may also have income sources other than your Critical Capital™. With any luck at all, Social Security will still be solvent when you retire. Perhaps you will receive income from your company's pension plan. This income reduces the income your Critical Capital™ would otherwise need to provide. Also, capital can be invested so that it can grow or produce income or do both. But at what rate should you assume it will grow? And what about income taxes?

If you haven't already reached Critical Capital™, there's the issue of savings or adding to your investment capital until you achieve Critical Capital™. This amount is often a function of how much you earn, what your taxes are, and how much you spend, all of which may vary over time with the changing circumstances of your life. And finally, there's the question of how your options figure into all of this!

Accurately calculating your Critical Capital™ requires taking all of the key financial factors of your life into consideration. There may be others peculiar to your situation that aren't among those mentioned above. Most people need professional assistance in putting together a truly accurate calculation and a plan to reach it. If you're really serious about achieving Critical Capital™, we'd recommend that you enlist the help of a qualified professional. It may be the best "investment" you make!

However, you're probably not quite ready to take that step or you may be determined to do it yourself, so here's a "quick and dirty" formula to estimate what your Critical Capital™ is:

Critical Capital™ = Annual Expenses / Rate of Return

Simply put, you take the amount of your annual living expenses and divide it by a rate of return. So there are basically only two figures you need to know: The amount of your annual living expenses and the rate of return. Let's look at those two numbers:

Annual Expenses

This is relatively simple. If you live by a budget or track your actual expenses on a computer, you know what your expenses are. If you don't, you can estimate your expenses by taking your annual gross income and subtracting taxes and savings. Or if you're spending everything your making, you can take your net "take home pay" and multiplying that amount by the number of pay periods in a year.

What about your home mortgage payment? You can either include this expense and assume that you'll find a way to spend that extra income once your mortgage is paid off, or you can subtract the amount of that payment from your annual living expenses and add the mortgage balance to the amount of capital you need. We'd recommend the latter, which modifies the formula to look like this:

Critical Capital™ =
( Annual Expenses [excluding Mortgage Payments] / Rate of Return )
+ Mortgage Loan Balance(s)

Now let's look at the other key number,

Rate of Return

The rate of return you use must take into account three factors:

1. How much risk you're willing to take,
2. Inflation, and
3. Income taxes.
   

How much risk you're willing to take, your "risk tolerance" is the key factor in deciding what a reasonable and realistic rate of return is. This can get a little complicated and a complete discussion is beyond the scope of this lesson. For right now let's start with the assumption that you have a moderate tolerance for risk. Historically, the rate of return on a moderate investment portfolio has been about 9%. Although past returns are no guarantee of future ones, the long-term historic rate of return is a reasonable place to start.

Inflation is also likely to be an ongoing economic reality, so it's best to plan for your expenses to increase over time. This means you must plan to provide an income stream that can increase every year with inflation. You can reasonably expect to do this if you your investment capital increases each year with inflation. This can be done by reinvesting, rather than distributing, an amount equal to the inflation rate. For example, if your capital earns 9% and inflation is 3%, you would allow 3% to be added to your investment capital and distribute the remaining 6%.

Now you have to face the unpleasant reality of income taxes. Although there are techniques to minimize this tax bite, for planning purposes, let's assume the income produced by our capital is taxable as "ordinary income". This is another area that can get very complex, but let's just assume for now that Federal and State income taxes will consume about 30% of this income. Following our example, 30% of the 6% is 1.8%. So after adjusting for income taxes, our "net after-tax inflation adjusted" rate of return is 4.2% (9% Gross Rate of Return - 3% inflation adjustment - 1.8% for income taxes = 4.2%). That's the number you would plug into the Rate of Return portion of the formula.