In my last post I talked about being financially free, but what exactly is it and how do you achieve it?
Financial freedom can be defined as the point a person reaches when they can afford to pay all living expenses without having to work. It sounds almost too good to be true, but it’s not. There are increasing numbers of people challenging the status quo and coming up with plans to retire early.
This article will review the steps needed to reach financial freedom including the mindset, ways to start saving, figuring out how much you need, and more!
While achieving financial freedom is certainly possible, it is by no means easy. Like many worthwhile pursuits, it can be difficult to achieve but incredibly rewarding. Getting into the correct mindset is the first thing that needs to happen on the road to financial freedom.
According to a 2013 Capital One 360 survey, a staggering 44% of Americans defined financial freedom as simply having no debt, while 26% said it means having enough saved for emergencies. While paying off debt is one of the first steps to financial freedom, it should by no means be the final goal. This is just one of many examples of how many people don’t even consider early retirement an option.
One of the first, and most difficult steps towards financial freedom is to believe that it’s possible. It sounds silly, but many people aren’t able to look past the current month’s expenses. If they have trouble with that, there’s no way they can be expected to plan for something many years in the future. It is only once you believe this is possible that your journey can begin.
One thing you can do is challenge the status quo. This means no more “keeping up with the Joneses” or spending for the sake of spending. This can be more difficult in some circles than others, and you will have to take it slow. You don’t have to avoid all luxuries, but it’s important that you save as much as possible if you want to retire early.
An important thing to remember is that you will get resistance when telling friends and family about your plans. Most people have been taught their whole life that you need to go to college, get a job, work for forty years, and then retire. Telling them otherwise may elicit negative responses, but it’s important to stay focused. Consider simply keeping your plans to yourself rather than sharing to ensure that any negative responses don’t impact your ambitions.
In the same Capital One survey mentioned above, over 18% of respondents said that “not knowing where to start” is the biggest obstacle in their path.
Once you’ve decided you want to become financially independent, you need to start saving as much as you can. Right now, it doesn’t matter that you don’t know how much you need to save. The important part is to start; we can worry about specific amounts later.
Start Small– If you’re having trouble, start small and work your way up. Saving even $10 or $20 per month is better than saving nothing. It’s much easier to increase your savings once you’ve set up a process.
Payoff Debt – Paying off debt is a major step towards early retirement. Always pay off any high-interest debt first (interest higher than you can get on your savings) before starting to save; if you don’t, you will lose money due to the interest rates on your debt.
Aim to Save 50% – Many people in the financial independence community recommend trying to save at least 50% of net income. Couples can think of this as saving one persons salary and living off the other one, assuming they make similar amounts. This may seem challenging but it is achievable.
Always Save for Retirement -It goes without saying, but don’t stop saving for traditional retirement in order to reach financial independence. Always contribute to your tax-advantaged accounts and make sure everything’s in order. There’s no sense in retiring at 40 if you have to go back to work in your 60s.
Invest! – A large percentage of that money you’re saving for financial independence should be invested in broad market, low cost, index funds. These carry much lower risk than investing in specific stocks and have historically done better than actively managed funds.
Get started! – Time is a very valuable resource for someone aiming at financial independence. It’s important to start as soon as possible. Starting earlier gives your savings more time to compound, which means having to save less each month to achieve the same results.
How Much Do You Need to Save?
Now that you’re saving, we need to find your financial freedom number. This is the amount of money you will need to have to be considered financially independent.
To do this, find out how much you spend each month to cover basic living expenses. (food, rent, utilities, etc.) Take this number and multiply it by 12 to find your yearly living expenses.
There are many ways to find out how much you need to retire early. The easiest way to get a rough number is to take your yearly expenses (calculated in the last step) and multiply them by 25. Having 25 times your salary in investments means that you should be able to live off of nothing but interest. The stock market averages 4% per year (if we factor in inflation). If you have 25 times your expenses in investments, 4% of that will be equal to your salary.
That number represents how much you need today in order to retire early. Each year the amount you save will need to be adjusted for inflation. On average, inflation decreases the value of a currency around 2%-3% per year. Tools like this one are a great way to easily compute the impact of inflation.
John does the math and finds out that he has $15,000 in basic living expenses every year. By multiplying that by 25, he finds that he needs to save $375,000 in order to retire early.
Once he retires, his $375,000 investment will return 4% on average, adjusted for inflation (7% average annual market return minus 3% annual inflation). This means his investment will return $15,000 per year, on average, which covers his living expenses. ($375,000*(0.04))
The 25 times annual expenses isn’t exact because things are rarely average. Some years will be worse than others, and that should be accounted for. One great calculator that helps do this is the FIRE (Financial Independence, Retire Early) Calc. This calculator is special because it runs your numbers through dozens of simulations representing historical stock-market performance. At the end, it shows you a graph of the performance and the percentage of successes.
Here are John’s results from the example above. As you can see, his portfolio has a 94.8% success rate:
Is 4% a Safe Withdrawal Rate?
There is great debate in the financial circles as to whether 4% is a safe withdrawal rate with some saying 3% is a better number to shoot for. A lot depends on your age, your risk tolerance and the way you live your life. If you will be 50+ when you stop working then 4% will likely be fine. Change this to 30 and you might want to build in a financial buffer and go for 3%.
The exercise above for John gave a 94.8% chance of success. Interestingly if the withdrawal rate is dropped to 3.6% his chances become 100%. The total sum John would need to have invested to meet this new withdrawal rate would be $418,000 (see graph below). To arrive at this value I simply increased the $375,000 in FIRECalc incrementally until I arrived at a 100% success rate of $418,000. The new withdrawal rate is simply $15,000/$418,000 = 0.036 = 3.6%.
In the 2nd example above we found that in a worst-case scenario that our $418,000 investment pot would last 30 years with a withdrawal rate of $15,000 per year. This may appear to be a disaster if you plan on retiring at 40. Come 70 and you are broke. This is where your pensions comes into play. Saving into a pension is one of the best ways to save for your retirement as your employer will at least match your contributions plus the government gives you additional benefits depending on your tax status. When you take your pension is up to you, currently from 55 in the UK but progressively increasing. You may take it as soon as you are eligible and together with your savings use the two to compliment each other. Alternatively, you could defer your pension and allow it to grow and only take it when your savings have been depleted. There are a number of options and some will be discussed in subsequent posts.
Each calculation is specific to the individual, so be sure to find out what works for you.
After all is said and done, the road to being financially free starts with a simple choice:
Will you pursue it or not? There are significant positives to saving more if you adopt the right mindset. Indeed, you’ll almost universally be better off.