The Actual Numbers Behind Financial Independence
Financial independence- and thereby early retirement for those who choose- is a worthy goal for those seeking to gain back control of their time. Simply put, financial independence is having enough savings or residual income to cover your expenses for the rest of your life without needing to rely on employment or others for assistance.
Typically, financial independence is thought of as your "retirement age" and not given further investigation by those under the age of 60. Why is this the case? Consider the following societal anchor points for retirement:
The assumption then is that we will need to work until our 60's, at minimum, before we can contemplate early retirement. That is, until we understand that there is actual evidence and analysis that it is possible to retire much sooner than your 60's, although access to the above benefits is likely nil.
Remember, financial independence is having enough savings and/or residual income to cover your expenses for the rest of your life without needing to rely on employment or others for assistance. Technically, this can occur at any age.
Financial independence, as well as early retirement, can then be simplified into mathematics based on investments and expenses, not age. A commonly held belief is that age is the single most important variable regarding retirement thus neglecting the most significant variable of all, your nest egg of invested savings. Do not allow the limiting beliefs of friends and family to lead you to the idea that you will also have to work for decades, in a job you dislike, just to catch a few golden years of retirement late in life. Financial independence is all about the math.
Without further ado, let us dig into the numbers of financial independence and early retirement. To calculate your financial independence number, proceed as follows:
[Expected Annual Expenses (in dollars per 12 months) x 25] = Financial independence # (in total dollars)
To solve for this individual equation, you will need to estimate your expected expenses per 12 months moving forward. This requires some initial expense tracking (not budgeting, but tracking) for at least 12 months. As a frame of reference, you may also look at previous 12 month periods if you anticipate your expenses will reasonably remain the same. If not, factor in recurring upcoming expenses such as increased health care premiums, increased or decreased housing expenses, etc.
Once you have your expected annual expenses, multiply them by 25 as above to determine how much you will need to your investment portfolio for financial independence and early retirement.
Why 25 times your expected annual expenses?
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
The overarching theme is that for those who are long-term savers, financial independence and early retirement is not as evasive as we might think. It's merely just one giant math problem.
The Math Shows Us That Early Retirement Is Possible
However, the above is a simple equation and is certainly no guarantee that your money will last forever. That said, consider that most people have no idea that there is actually solid research- as well as a way to calculate- the path to financial independence and early retirement.
Let this math be your framework moving forward. Understand that the above 4% withdrawal rate has some built-in assumptions and problems that need to be addressed and fully understood before you begin withdrawing your money. I will be highlighting those in another post. My guess is that if this is the first time you are hearing about financial independence and the possibility of early retirement, you likely have some more saving and investing to do before you need to worry about the precise mechanics of how you will withdrawal 4% of your money.
Why Doesn't Everybody Know About This?
It is not entirely clear to me why this information is not more widely understood. I do, however, have some theories that I can share.
Theory 1. Our financial advisers and gatekeepers are paid to keep us contributing and investing to long-term programs. The problem with financial advisers largely controlling the dissemination of personal finance information to the public is that it is likely their interests will come before yours (unless you have a "fiduciary" adviser). If your adviser's compensation is based on assets under management (AUM) or load-fees, then their livelihood is based on you continuing to contribute and grow your nest egg. Again, this sounds like a good thing and perhaps it is if you detest the idea of managing your own money- or otherwise have a very complex estate to manage. However, paying higher fees and getting encouragement to continue working and investing for many years beyond financial independence will keep you working longer than you otherwise may have needed.
Theory 2. Most people are terrible savers. Period.
Theory 3. New media anchors us to minimum retirement age in our 60's, for all the reasons mentioned already above.
Theory 4. Our parents, grandparents, or guardians worked forever and thus gave us a similar script with which to framework our own lives.