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The Harsh Reality For Many Chasing Financial Independence
The pursuit of financial independence, for many, is the holy grail of personal finance. However, a common mistake is often made in pursuing such a financial milestone. Let's take a closer look at where pursuing early retirement and financial independence often goes wrong in the FIRE community.
Allowing Your "F.I. Number" to Rule Your World
Let me first start by saying financial independence is a worthy goal for many. Personally, I am not yet financially independent but am halfway towards our goal. However, use care when first starting out pursing F.I. as you can quickly lead a life of deprivation instead of enjoying the values of frugality.
Financial independence is loosely set at 25x annual expenses (aka your F.I. number). This requires some initial expense tracking (not budgeting, but tracking) for at least 12 months. You may also look at previous 12 month periods if you anticipate your expenses will reasonably remain the same. Take these expenses for an entire year and multiply them by 25.
Why 25? This is related to the 4 percent rule of thumb originated from research conducted by William Bengen in 1994. He evaluated 4 percent annual withdrawals from a portfolio with a minimum retirement duration of 30 years. His research concluded the following:
Assuming a minimum requirement of 30 years of portfolio longevity, a first-year withdrawal of 4 percent, followed by inflation-adjusted withdrawals in subsequent years, should be safe. Source
This research permitted the financial independence community to put an actual number on the pursuit of early or regular retirement. Saving at least 25 times your annual means that your first year withdrawal of 4% is consistent with the total amount of money necessary for the rule to remain in effect.
Now, there are a few problems with chasing this number.
Problem #1 - Bengen's research assumes you maintain a 50/50 stocks to bonds portfolio, rebalanced annually. For the young folks out there, 50% bonds feels way too conservative!
Problem #2 - The rule only applies to money held in tax-deferred accounts. This is because your overall portfolio return would be reduced when factoring in capital gains taxes and dividend taxes therefore reducing the longevity of your money if you continue 4% withdrawals.
Bengen actually said the following in his paper:
If the assets had been held in a taxable account, the conclusion might have been different, as the certainty of substantial capital-gains taxes would have to be weighed against the probability of a large stock-market decline, and the loss of the benefit of a step-up in basis upon death. Source
Problem #3 - Your F.I. number is probably bigger than you think since we are not including home equity and largely ignoring taxation. Having an even larger financial independence number is disheartening since your original assumptions were probably based on net worth as opposed to available balance in tax-deferred accounts. This is a very common mistake in the FIRE community!
Problem #4 - Past returns are not indicative of future performance. This data was based on historical observations, not future predictions. Just because these 4% withdrawals survived in a 50/50 stocks to bonds portfolio in the past, does not mean the rule will hold up for the future- although I am still personally betting that it will.
This is the point where attainment of your F.I. number can quickly become pathological. Frugality is not about deprivation and therefore neither is financial independence. However, you can quickly become too consumed with your financial independence status and overall net worth and lose site of the joys of valuing a dollar and practicing frugality consciously. I am not implying that we all need to experience a life of sunshine and rainbows with no hardship along the way. Rather, I am cautioning against allowing money and net worth to rule your world over all else. I have personally made this mistake and do not wish to repeat it nor have others emulate it.
Ways to Avoid Unhappiness Pursuing Financial Independence
First and foremost- this is one I have resisted the most- automate your savings. Automating your savings removes the necessity to consciously transfer money into your investible accounts and reduces the likelihood of living in the spreadsheet (see Ramit Sethi's book I Will Teach You To Be Rich for more on this).
Second, get clear on what matters most to you on this journey. The number is a secondary outcome and should not be the primary driver of your pursuit. Most of us want more freedom to make conscious decisions with what we do with our time rather than being beholden to a toxic work environment or arbitrary rules set forth by our employers.
Third, remember that their are no hard and fast rules for finances. Be flexible and willing to adapt on this journey. For example, the 4% rule is generally a "rule of thumb" and is not meant to be a guarantee. This withdrawal may actually fail in the future depending on market conditions.
Further, consider if you even need 25 times annual expenses to make a true career or life change. Suppose you had $250k saved and only spent $50k per year. You still have 5 years worth of expenses saved up! This should be more than enough cushion to make a move on some real life changes if you are not happy in your present situation. If you truly dislike what you are doing please do not feel that you have to get to full financial independence before you make a move. Often times, you can begin making radical changes much sooner. If you love your job, this entire paragraph does not apply and you will likely benefit from staying the course in your pursuit.
Lastly, control what you can control. As much as we like control in our lives, admittedly their are things that are beyond your reach. For instance, take the market conditions. Although the 4% rule worked through previously difficult economic times, again there is no guarantee it will work in the future. Can you really control what the market will do in the future? No. Therefore there is no need to worry about it. Use the 4% rule as a general framework, control what you can control, and be willing to abide by the suggestions above as time goes on.
Best of luck in your journey and remember to keep things in perspective.