4-3-2-1 Approach to Financial Freedom

I speak to clients on a daily basis regarding management of their wealth. One common trend I observe is many people aspire to reach financial freedom at some point in their lives, but most are clueless how to get there. Financial freedom is the point in your life when your work becomes an option rather than a means of survival.

In this article, I outline some broad strategies on how you can get started along this journey towards financial freedom.

The 4-3-2-1 Approach

One simple rule of thumb I tend to adopt is going by the 4-3-2-1 ratios to budgeting. This ratio allocates 40% of your income towards expenses, 30% towards housing, 20% towards savings and investments and 10% towards insurance. While this is by no means a hard fixed rule, it is a useful guide to ensure you are not over-allocating resources towards any one single area while neglecting the rest.

For a young person who has yet to acquire the first property, the 30% for housing can be channeled towards savings and investments or set aside for the eventual down payment or renovation of the house. A person with fewer liabilities or dependents may choose to allocate less towards insurance and more towards savings and investments so they can achieve financial freedom at an earlier age. Allocating 40% of income towards personal expenses is usually comfortable for most without compromising on lifestyle consumption.

Insurance as the foundation

In the overall wealth management strategy, insurance forms the foundation of the financial portfolio. In the event of a major illness or accident, insurance serves as a buffer to prevent your wealth from being wiped out in a single catastrophic event. For hospitalisation and surgical coverage, it is a good idea to explore integrated shield plans offered by private insurers to supplement your basic Medishield Life. These generally offer a more comprehensive cover and provide more options when it comes to treatment.

In terms of life insurance, I tend to recommend between five to ten years of annual income worth of coverage as a guide. This will usually cover you for critical illness, total permanent disability and death. In the event of critical illness, the payout from the critical illness cover will make up for expenses not covered by your hospitalisation and surgical plans while replacing your loss income when you recuperate. In the unfortunate event of death, the death benefit will be paid out to your beneficiaries to take care of your dependents.

This insurance portfolio can be supplemented by accident cover, disability income and early stage critical illness to provide a more comprehensive insurance portfolio. By structuring the portfolio with a mixture of whole life, term or investment-linked policies, most people should have no issues fitting their insurance portfolio into 10% of income.

Generating passive income through savings and investments      

For someone who starts out relatively young, allocating 20% of income towards savings and investments is a good starting point to work towards financial freedom. After setting up an emergency fund of about 3 to 6 months of your income, this portion of your income should be channeled towards instruments such as stocks, exchange traded funds (ETFs), unit trusts or endowments to make your funds work harder for you.  If you have yet to purchase your first property, it is a good idea to channel the additional 30% from housing into savings and investments. This gives you a head start in terms of accumulating and compounding your wealth.

One of the common issues I face with regard to investment planning is people tend to invest without an idea what they are investing for. This is a concern because there is no time frame and estimation on the amount they are trying to accumulate. There is no way to identify if they are on track towards what they are working for. One key step I try to do is to work out with clients exactly when do they intend to reach financial freedom and how much funds are needed.

Financial Freedom for the Next Generation

If the earlier steps are done right, most people should have more than what they require in their life time at some point. This is when they should look into how their assets are distributed when they are gone. Estate and legacy planning tends to be an after-thought for many people. The common approach tends to be whatever is not spent will be left behind for the next generation. Singaporeans also tend to favour property or real estate as an asset class. What many fail to realise is your best investment can very often be your worst estate plan. In particular, property can be tricky if not handled properly.

For example, in handing down a property with an outstanding loan, one potential issue is if the beneficiaries are unable to take up the loan. They may be left with no choice but to sell the property which may not be the intention of the giver. They may also be exposed to market risks if market conditions are not favourable. Having a well thought out estate plan will go a long way towards mitigating these issues and assisting your next generation to reach financial freedom earlier in their lives.

While I have outlined some broad strokes in managing your wealth and working towards financial freedom, it is important to recognise every individual may have unique circumstances which may require different approaches. For specific advice on how to better manage your wealth, do consult a qualified financial adviser to assess your current financial situation.