Achieving financial independence is a great goal. Not having the overhang of financial pressure changes your perspective on why you do what you do, and let’s you take calculated risks with your time. That being said, it is really difficult to figure out what it will take to achieve financial independence & because of this many people have (sometimes) unnecessary anxiety about their finances today. Having a strong understanding of what your goal is and how you are tracking towards it can either give you confidence that you are on the right path or tell you that you need to course correct early on.
To help you figure out what achieving financial independence means for you, I wanted to talk about one of the most misunderstood tools in calculating your net worth requirement to achieve financial independence: The 4% rule.
The 4% rule in personal finance says that once your expenses are 4% of your investments or less, you can live off your investment income. This leads a good number of people to calculate their ‘financial independence’ number by taking their average annual expenses and multiplying it by 25x.
For example, if you spend ~$2.5K/month or $30K/year, this rule would say you needed ~$750K saved up to live off your investment income and be financially independent. It’s an easy to calculate rule of thumb and has been used…and reused…forever. Unfortunately, it’s also very misleading if you don’t dig a little deeper.
Today, I’m going to talk about how to actually think about your ‘FI number’ (I’m purposefully not calling it a FIRE number, because the retiring early part is less of a focus for me).
Let’s start by discussing a few reasons it’s not as simple as multiplying your expenses by 25x.
Your expenses tend to go up over time
This is an especially important one for younger people, but the expenses you have when you are 25 living in a studio apartment that you split with your SO are probably a little lower than what you’ll be spending when you are 45 with 2 kids.
Since I am pretty conservative with my finances, I try and calculate my FI number based on the maximum annual expenses I am likely to have. As a result, I had to forecast all the costs I expect to have down the line.
Because I am a giant nerd when it comes to this stuff, I decided to project out what I thought my expenses might be through 2040, estimating when I would buy a house, car, have kids, etc., and added some inflation multipliers to all of that (don’t forget that in addition to lifestyle creep, prices themselves go up over time). All I can say is life can be really expensive…
If you add in things like childcare, 529B contributions / schooling, healthcare (you can’t claim you are financially independent if you are dependent on your job for subsidized healthcare), etc., your expense number gets pretty large.
The silver lining here if all of that freaks you out is that people usually have a peak spending level that abates fairly quickly later in life and generally lowers in perpetuity thereafter. However, it’s hard to say you have hit your number when in reality for a good chunk of time you would need to withdraw much more than 4% to pay your expenses.
Not all savings are equal
Adding to the complexity with calculating your FI number is that not all of your savings are easily accessible or as valuable.
Retirement accounts: If 90% of your savings are in retirement accounts that you can’t touch till you are 59 ½ and you are in your 20s/30s now, then it is a lot harder to think of yourself as financially independent. This doesn’t mean you can’t count savings in retirement accounts as they will still grow over time and eventually be accessible to you, but you need to make sure that you have also saved a substantial portion in non-retirement accounts if you want to be financially independent.
Tax: The 4% rule is saying that as long as you can withdraw 4% or less from your savings each year, you should be able to live off your investment income in any economic climate. That being said, withdrawing 4% doesn’t necessarily mean you can spend all of that 4%. You will still likely be paying taxes on whatever you withdraw, so will need to incorporate that into your calculation. Your withdrawals could either be taxed as income, as long-term capital gains, or if its from a post-tax retirement account you could be paying no tax at all. The value of a Roth IRA / Roth 401K is that you have already paid your tax and when you withdraw it the capital gains are not taxed, which makes it incredibly valuable. Either ways you need to think about your expected taxes on any withdrawals you’d have to make
4% is likely outdated at this point
The reason that 4% was chosen, was that at one point you could reasonably expect to earn 4% in excess of inflation through your investments in a relatively safe fashion. The 10Y treasury yield wasn’t always <2% as shocking as that is.
Unfortunately, as interest rates have come down, the expected return on assets has declined as well. In fact, in the current economic climate, you have a 1Y treasury yield of ~0.5% and inflation at 5-7% so you would be hard pressed to safely invest at 4% in excess of inflation, which is what you would need in order to withdraw 4% of your savings each year.
High inflation non-withstanding, as we are unlikely to have a negative real rate environment forever, you can probably count on closer to 1-2% as a safer withdrawal number. I’m not trying to get that exact, because its fairly difficult to do, but directionally it has come down a good bit.
If we return to our initial example of a 25-year-old who spent ~$2.5K / month now, we can see how their FI number grows rapidly with all of these adjustments:
- Expenses increase: They expect their expenses to quadruple to $10K/month over time due to natural cost of living increases & adding in healthcare (this might sound like a lot, but run the numbers I mentioned earlier and it might be more believable than you think)
- Tax: They expect a 20% tax rate on any withdrawals so need to be able to withdraw $12.5K / month before taxes
- Withdrawal rate: They believe their withdrawal rate is closer to 1.5% vs. 4% given how they can safely invest their money
This would mean they would have to have savings of: ($12,500/month * 12 months) / 1.5% = $10M to achieve their true FI number, or the number at which they could live forever off just the investment income of their portfolio.
Now that might sound ridiculous to you, and you aren’t wrong to be shocked. It has gotten a LOT harder to achieve financial independence in a low interest rate environment. Here are a few things that might make you feel a bit better about things though:
- You can withdraw principle: You don’t have to live forever without touching your principle. That 1.5% safe withdrawal rate assumes you never want to touch the net worth you have invested and just want to live off investment returns, however, nobody is saying you can’t
- Your expenses eventually peak and usually start decreasing afterwards: You will likely not be living at your max expense rate forever, so later in life this exercise becomes easier. For example, you could pay off the house, no longer have kids to take care of, move to a smaller place, travel less, etc.
Another major factor in building confidence around your FI number is finding sources of long-term cash flow (see related post on why cash flow is the key to FI). Because of the inherent uncertainty in places like equity markets, you have to take a fairly conservative view of your withdrawal rate. However, if you have some income streams that can last even without a job (e.g., rental properties, etc.), you may be able to reduce your FI significantly. For example, if you needed $100K/year (a $10M FI number as we saw above) but had ~$30K post-tax cash flow from rental properties after expenses, your FI number would decrease to ~$5.8M (more than a 40% decline). Rental properties do still require capital, but your stable cash flow returns can be much higher depending on your property (Economics of rental properties). If you expect ~5% cashflow returns given the leveraged nature of properties, you would be able to get $37.5K ($30K after 20% tax) with just $750K in invested capital (far less than the $4M it reduces your FI number by).
Of course, most of these cash flow generating solutions are not truly passive & by no means risk-free (as we saw in 08), however, the returns are on average much more stable than your equity exposure, and they can make achieving FI much more realistic.
Given that if you are looking to build your nest egg, put some thought into how to acquire cash flow generating assets over time.
Good lucking chasing financial independence!
RWM
