What is Financial Independence?
Financial Independence (FI) is when you have enough passive income* or investments to cover your living expenses for the rest of your life.
Once you reach financial independence, your life does not depend on income generated from your ability to work anymore. You can choose to retire early or continue to work. You can focus your energy on pursuing passions and hobbies or volunteering. You can follow your dreams or other projects without worrying whether you will be able to cover your living expenses or generate income. Financial independence enables you to reorganize your life with money taking a backseat to your decision-making process.
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What’s interesting about Financial Independence?
I discovered the FIRE – Financial Independence Retire Early movement five years ago. The FIRE movement emphasizes aggressively saving and investing in low-cost index funds to have the option to retire early. I have been very interested in that philosophy since then. While I have my reservations about the FIRE movement, I appreciate that it encourages you to save and start planning for retirement early. The FIRE philosophy also encourages you to optimize your lifestyle and to spend money on what matters to you.
Related post: The 50/30/20 Budgeting method
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What does FIRE represent?
In the FIRE community, the “Four Percent’ and “Multiply by 25” Rules are often used as the baseline to calculating your FIRE number. The Four Percent Rule was created based on average stock market returns over a period of 50 years adjusted for inflation. The idea is that you can withdraw four percent of your portfolio every year without risking running out of money or touching your investment principal. The Multiply by 25 rule estimates your retirement needs by multiplying your annual expenses by 25. It represents the amount to which you would apply the Four Percent Rule. At that point, the FIRE community considers that you have reached financial independence.
What’s your FIRE number?
Often, people save for retirement without having any idea of how much they will need. Estimating your financial independence number is a great way to begin working towards your retirement goals.
- Calculate your living expenses
- Determine your FIRE number
Financial Independence = annual expenses * 25
Based on the FI formula, you reach financial independence, once you have saved up 25 times your annual spending.
As an example, if your living expenses are 30,000 dollars a year, you will hit your FI number once your investments have reached 750,000 dollars.
Does that mean you need to save 750,000 dollars? No, thanks to investment returns, you will need to save considerably less.
Let’s assume that you are 30 years old, starting with an initial investment of 5,000 dollars, and your goal is to reach FI by 50 years old.
|FV (Future Value)|
|N (# of periods)|
|PMT made at the
of each compound period
You will need to contribute $19,952.50 at the end of each period to reach the future value of $750,000.00.
|FV (Future Value)||$750,000.16|
|PV (Present Value)||$233,853.59|
|N (Number of Periods)||20.000|
|I/Y (Interest Rate)||6.000%|
|PMT (Periodic Payment)||$19,952.50|
Taking a 6% return on your portfolio over the next 20 years, you would need to save a little less than 20,000 dollars a year to reach FI at 50. Twenty thousand dollars a year is a significant amount of money. However, once you know why you would be interested in pursuing FI, and you have an idea of what would be necessary to reach it, you can begin to think about how to achieve your goal.
Once you have calculated your annual expenses, you can use the calculator in the calculator.net link attached to determine how much you would need to save every year, based on your initial investment, target FIRE number, and estimated years until retirement.
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The shortcomings of FIRE
The Four Percent assumes that your investments will generate a seven percent long-term annualized rate of return and a four percent real rate after three percent of inflation. But people close to retirement and retirees typically keep their portfolio in lower-return investments. Also, other things to consider when calculating your financial independence number are healthcare expenses and unexpected events. Healthcare expenses usually increase later in life. Unexpected events can also negatively impact your financial future.
However, if you have assets outside of the market that generate passive income, that should reduce the amount of money you need to reach FIRE.
Most followers of the FIRE movement are aware of the risks. Some people use the “Multiply by 33 Rule” and a “Three Percent Rule” for precautionary measures. Under these rules, the assumptions are a six percent annualized long-term rate of return and a real return of three percent after three percent of inflation. Some members of the FIRE movement choose to have other sources of passive income to compensate for the risks. Others redirect their lives after reaching FIRE and find creative ways to continue to earn income while maintaining their freedom.
Photo credit: Pixabay
Financial independence is about having more freedom to do what matters to you in life. The Four Percent and Multiply by 25 Rules are a great starting point on your journey to financial independence. If it is something that interests you, I encourage you to take the first step by calculating your FI number.
What are your thoughts on FIRE?
“Working because you want to, not because you have to is financial freedom.”Tony Robbins
*Passive income is income that requires you to provide little to no effort to earn.