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Some random browsing brought me to the Wikipedia page on Financial Independence, and I'm having trouble making sense of something it says. Below is the whole extract, provided in full to make it easy to see what's being discussed, and highlighted in bold is the sentence I'm having trouble understanding.

"It does not matter how old or young someone is or how much money they have or make. If they can generate enough money to meet their needs from sources other than their primary occupation, then they have achieved financial independence. Age is potentially irrelevant with respect to financial independence. If they are 25 years old and their expenses are only $100 per month and they have assets that generate $101 or more per month, they have achieved financial independence, and they are now free to do things that they enjoy without having to worry as much. If, on the other hand, they are 50 years old and earn a million dollars a month but still have expenses above a million dollars a month, then they are not financially independent because they still have to generate the difference each month just to stay even.

However, this needs to take into consideration the effects of inflation. If a person needs $100/month for living expenses today, that figure will be $105/month next year and $110.25/month in the following year to support the same lifestyle assuming a 5% annual inflation rate. Therefore, if the person in the above example obtains their passive income from a perpetuity, there will be a time when they lose their financial independence because of inflation."

The Wikipedia entry on "perpetuity" confused me more.

So, in layman's terms, what exactly is a "perpetuity", and why will inflation cause you to lose your financial independence at some point if you secured your money in one?

  • It might be more helpful if you explain what about the article on perpetuity you didn't understand. You pasted the part about financial independence, but as you say, your misunderstanding seems to have more to do with the notion of perpetuity. – BrenBarn Apr 27 '14 at 1:15
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In short, if your expenses rise with inflation but your income does not, your expenses will eventually exceed your income.

As the article on perpetuities says, a perpetuity is an annuity that pays forever. An annuity is a financial arrangement whereby you are paid a fixed sum every so often for a period of time. Hence, a perpetuity is an arrangement whereby you are paid a fixed sum every so often until you die. Since the sum is fixed in nominal dollars (or other currency units), it will become worth less and less in real dollars as time goes on, which is what will erode your financial independence.

To adapt the example from the article that you quote: If you buy an annuity that will pay you $101 per month and your expenses are $100 per month, you may seem to be financially independent. However, if inflation is 2% per year, then next year your expenses will be $102, but the annuity will still only pay you $100. At that point you will no longer be financially independent, since the annuity no longer covers your expenses.

There are some senses in which the article's statement is inaccurate in practical terms --- e.g., annuities need not always have fixed payments but may be adjusted for inflation, also there aren't many real perpetuities in existence anyway, and plus it doesn't matter whether the source of the income is an annuity or something else --- but that is the gist of what the article is saying.

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    I did get you to write an answer didn't I?;) – littleadv Apr 27 '14 at 2:40
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    "Hence, a perpetuity is an arrangement whereby you are paid a fixed sum every so often until you die." So what's the difference between the perpetuity and an annuity as far as the owner is concerned since the annuity also pays a fixed amount of money on a periodic basis until the owner dies? Please do not drag in variations on annuity terms such as joint life, joint life plus n-year-certain etc, and let's just stick to basic annuity versus perpetuity. How do the two differ as far as the owner is concerned? – Dilip Sarwate Apr 27 '14 at 13:16
  • @DilipSarwate A perpetuity might be transferable upon death to heirs. It is like a consol bond, with payout forever. An annuity is based on mortality rates, but more importantly, it ends at death, and cannot be transferred. – Ellie Kesselman Apr 27 '14 at 16:33
  • @DilipSarwate: In addition what Feral Oink says, an annuity need not keep going until death (e.g., mortgage payments made to you). Regardless, as I mention at the end of my answer, that's not really important for the meaning of the passage. It doesn't really matter whether the source of the income is a perpetuity, an annuity, a goose laying golden eggs, or a giant box of cash under your mattress. The point is just that if your income is fixed and your expenses increase, your expenses can grow beyond your income. – BrenBarn Apr 27 '14 at 16:38
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    @DilipSarwate Wouldn't the distinction that a perpetuity might be transferable upon death to heirs, whereas an annuity would not, be relevant to the owner, as well as being in layman's terms? – Ellie Kesselman Apr 28 '14 at 18:21

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