Note: This is part 3 of a 5-part introduction to financial independence and understanding. Make sure to read the whole series to really grasp what Money Tofu is all about!
If you’ve read about the 3 reasons to achieve financial independence, you may be wondering how it is even possible.
Reading this one article won’t cause you to become a financial guru who can immediately achieve all your goals. The answer to that question requires bettering your financial understanding and setting goals to achieve throughout many years (which the rest of Money Tofu can hopefully help with). However, this article will introduce the basic concept and put you on the right path.
Let’s get started!
How do you know when you are FI?
The first thing we need to know is how to identify when you are financially independent. If we don’t know where the goal is, how can we formulate any kind of plan to get there?
In a sense, it is extremely easy to know if you are financially independent or not. By its definition, being FI means that you have enough wealth such that you will not use up all of it for the rest of your life. That’s it!
Though that may seem like a simple idea, there are actually a few different, yet very important concepts to understand.
What it means to “have enough wealth” is that you have accumulated a large enough amount of money that can cover all of your expenses for the rest of your life. However, there are several different ways this can happen.
Let’s consider the following two scenarios:
- Alice is 67 years old (“normal” retirement age) and expects to live for another 30 years. Her living expenses are estimated to be $100,000 per year going forward.
- Bob is 37 years old (an “early” retirement age) and expects to live for another 60 years. His living expenses are also estimated to be $100,000 per year going forward.
Suppose you have all of your money saved in a mattress (or more realistically a safe) at home. This money is earning no interest, but has no risk of getting lost either. Let’s also assume inflation is not a factor. In this case, the math is extremely simple. $100,000/year of expenses is simply multiplied by the number of years left to live. Thus, Alice would need $3 million dollars while Bob would need $6 million in order to be considered financially independent.
Savings Account Method
Suppose you have all of your money in a bank savings account that also generates a decent amount of interest. That means the money is still safe and accessible with no risk of getting lost, but is also growing over time. Let’s assume that the interest amount results in a fixed 1.5% per year earnings (which is close to what online savings accounts offered at the time this article was written) and there are no income taxes or inflation.
Under this system, Alice would need only just under $2.5 million today to last 30 years, while Bob would need about $4 million. Because the money is being saved and earning some interest, the amount they need is less than if they had saved money in a mattress.
Suppose you have all of your money in an investment account with only 1 index fund that tracks the total US stock market. This is more risky, since the stock market can go down. However, the average return per year in the stock market has been about 7% in the long run (actually the S&P500 has shown real returns of 7% during that time frame), so the money you start with increases far quicker than the previous 2 methods.
With investing, Alice would need just above $1.3 million today to last 30 years, while Bob would need a little less than $1.5 million. Notice that as the return on your wealth increases, the difference in starting amount matters less to how long it can last for a given spending amount.
Infinite Time Horizon
Under which of the 3 methods above can Alive and Bob truly be considered as financially independent? The answer: none of them. However, the Investment Method gets the closest.
You see, there is a crucial piece missing (besides inflation and a volatile stock market) in the above scenarios: the life expectancy timeframe. Here, we set arbitrary 30 and 60 year time horizons, after which we say that the starting wealth can go to 0. The problem is that life expectancy is just that: an expectation (in math, it’s also called an average). That means you have a fantastic chance of living LONGER than expected. So if you end up with no money, then you were not FI to begin with.
The best way to think about FI is to think about the horizon being infinite, especially if you have the goal of retiring early. That is, being FI means you should have enough money to last essentially forever. How can that be? Simple: when income = expenses, you will never run out of money.
When you are working a full-time job, ideally income > expenses. The tricky part is how to get enough income to cover expenses without the need to work a job. Sure, if you amass so much money that even the paltry 1.5% interest from bank savings accounts generates enough income to cover all your expenses (around $6.7 million to to match $100k yearly spend), you are most certainly FI.
However, targeting that sum is generally not realistic nor the most efficient thing to do for most of us. It turns out that scientific research has illuminated how we can calculate a more reasonable and achievable target, allowing those of us with dreams of early retirement to have a viable plan.
The science behind financial independence
There is a famous study in the FI community called the Trinity study that generated something called “the 4 percent rule.” This research looked at the stock market over a period from 1925-1995 in order to determine what would happen if you started with a sum of money, withdrew a certain amount every year for spending expenses, and let the remainder grow. Sound like the concept of FI? It is!
The gist of the study is that the amount of money you can withdraw on a yearly basis (also known as the Safe Withdrawal Rate or SWR) is about 4% of the initial starting sum (not 4% of the changing balance every year). That means if you started with $1 million, you can safely withdraw $40,000 every year for expenses, and the amount invested should be able to last you for at least 30 years.
With this knowledge, you can see that if you know your yearly spending, you can easily calculate how much money you would need to sustain that level of spending (and thus be FI). If your yearly spending if $100,000, you need $2.5 million to be FI.
But wait, what’s this about 30 years? I thought being FI means forever!
Well, the Trinity study only looked at periods of up to 30 years at a time, so it doesn’t say for certain that a 4% SWR will let your portfolio last forever. However, there is also nothing that says you must withdraw 4% for expenses each year. You can plan a more conservative approach if desired, with lower SWR that should make it much more likely for your portfolio to last a longer time.
At 3%, for example, yearly spending of $100,000 is possible with a starting balance of $3.3 million.
More realistic and achievable numbers
If you’ve been following along, you may also be thinking that the numbers presented thus far seem rather high. Do you really need $3+ million or more to become financially independent? Is that even something you can hope to achieve in a reasonable timeframe?
The good news is that the examples I created above all have some assumptions that you can tweak to fit your own needs. By doing so, the actual target FI number will also change. Let’s talk about what these assumptions are.
You might have noticed that the amount of money you need to become financially independent is entirely dependent on your level of spending. If you can live in a more cost-effective place, with fewer luxuries, or just don’t need to spend much money to enjoy life, then lowering your spending budget will greatly lower the time to reach FI. As we saw in the examples above, each dollar of spending budget needs to be multiplied by 25 (by the 4% rule) to determine the amount of savings you need for FI.
The SWR you choose (and thus the spending multiplier) is the another factor. If you are very risk-averse and like to play it safe, you will choose a lower SWR (and higher multiplier), causing you to require more money before declaring yourself FI. If you have a more risky personality, you can do with a a higher SWR (though probably should not go much above 4.5% or 5%).
The final factor that determines your time to FI is your income level. Bringing in more money means you can achieve your target goal faster for the level of spending intended. Be careful, however, to not let lifestyle inflation cause your spending to increase alongside income. Also, fully or partially retiring doesn’t mean you have 0 income starting from that point. You may be interested in some income generating activities, such as hobbies that you also get paid for, working part-time, and so forth.
FI is simple, yet complex
The amount of money you need to be considered FI is primarily dependent on spending. Lowering the amount of money you need to spend lowers the amount you need to save in order to become FI. Increasing your risk tolerance (and thus the SWR) has a multiplicative effect on spending levels.
For example, let’s take a look at this table that calculates the target FI number based on spend/year and SWR:
|Spend/Year||3% SWR||3.5% SWR||4% SWR||4.5% SWR|
Additional income past what you need to save to reach your FI target can be thought of as direct reduction of spending (and thus lowering the FI target). For example, if you plan to spend $60,000/year and believe you will earn $20,000/year (after taxes) after you make lifestyle changes once you’ve reached your FI target, you would use $40,000/year as your spending number in your FI target calculation.
In summary, achieving financial independence is about earning money and saving enough of it to cover spending needs for the rest of your life. It is a simple concept, but there are numerous complexities on creating and executing a strategy to make FI a reality. The rest of Money Tofu will get into more detail about these strategies.
If it sounds like FI could potentially be difficult to achieve, that’s because it requires a certain mindset, dedication, and way of life that many may not be used to.
In fact, that’s the topic of the next article.