How much is enough to be financially independent?

In the last two posts, I asked how much is enough, and what it means to be financially independent.

Now that you know how much you need, and where you sit on the financial independence scale, let’s combine the two: how much is enough to be financially independent?

We often hear big numbers floated around – you need at least $200,000 in superannuation to even think of a self-managed superannuation fund. You need $1 million if you want a basic retirement – better make that $2 million to be safe, say authors like Kirkpatrick in his free ebook, Can I Retire Yet? (Although it’s worth noting that Kirkpatrick’s view of a ‘restrained’ lifestyle includes living in an upscale neighbourhood, owning multiple vehicles, going on vacations, dining out, enjoying lots of entertainment and frequent cafe and bar visits). So maybe we don’t need $2 million after all?

Certainly, it’s important not to underestimate our future needs, the powers of inflation and taxation to erode our savings, and the unexpected like health issues or home repairs that may crop up – but fixating upon massive figures can make planning for the future seem like such an impossible task, we just give up.

In the ‘How much is enough?’ post, we worked out how to come up with your own personal calculation of how much is enough. Once you have this magic number, you can start to project how much you might need to become financially independent.

One rule of thumb that you’ll see on a lot of personal finance websites and books is the 4% rule – or what I like to call the rule of 25.

What is the 4% rule (Rule of 25)?

The 4% referred to is considered the ‘safe withdrawal rate’ – that is, how much money, after taxes and inflation, you should be able to withdraw each year without touching the principal invested.

The 25 (100% divided by 4% = 25) is the number of years’ worth of expenses you will need to invest.

In Early Retirement Extreme, Jacob Lund Fisker points out that when the growth of the portfolio is equal to the amount withdrawn, the portfolio will last for ever, because the principal is kept and never dipped into. This is called a “perpetuity”. He notes that in most cases, a fund lasting 30 years should be safe to retire on.

If you withdraw less money than what is earned, your principal will continue to grow each year.

To work out a rough figure of how much you might need to invest, simply multiply your annual expenses by 25.

  • If your annual expenses are $10,000: $10,000 x 25 = $250,000.
  • If your annual expenses are $12,000: $12,000 x 25 = $300,000.
  • If your annual expenses are $25,000: $25,000 x 25 = $625,000.
  • If your annual expenses are $30,000: $30,000 x 25 = $750,000.
  • If your annual expenses are $40,000: $40,000 x 25 = $1,000,000.
  • If your annual expenses are $50,000: $50,000 x 25 = $1,250,000.

Why 4%?

The most often-cited evidence for the 4% safe withdrawal rate is the Trinity Study, which showed that at a withdrawal rate of 4-5% of the initial portfolio, adjusted for inflation, there would be a reasonable expectation of ‘success’ – defined as your money not running out (to $0) over a 30 year retirement. If you’re planning on becoming financially independent – in effect, retiring extremely early – a lower withdrawal rate (4% or less) is advisable, as you will (hopefully!) be needing more than 30 years’ income!

One article suggests, however, that these simulations were based on the worst case scenarios for each time period – and therefore, it’s likely that at a 4% withdrawal rate, you could actually finish with more money than you started.

Still, like any approximate percentage, this figure should be treated with some caution. An international perspective on safe withdrawal rates suggests that he majority of studies to date have relied on historical US data – and largely from a period in which America made huge economic gains. Similar gains cannot necessarily be assumed in the future, or in other contexts.

The study finds that, using historical data for a number of countries, only 4 had a safe withdrawal rate of 4% or over. Australia, for example, came in at only 3.68%. The historical data used to come to these conclusions was from 1900-1979. The section of the report which examined returns for 1900-2008 found that ‘Australia boasts the distinction of being the only country with both a higher return (the highest of all) and lower volatility than the United States’.

Another factor the above study was unable to take into consideration is management. In other words, it assumed continual investment in the same average stocks and bonds, rather than what we would hope any real investor would do, which is to periodically evaluate their returns and perhaps reallocate – as well as potentially use other asset classes, like rental property, which may be more attractive at times.

Can I Retire Yet? reports that many long-standing endowments and charities use 5% as their annual withdrawal rate. In fact, some recommend 2-3%, given the ‘sorry state of world financial affairs, and the unknown prospects for future growth’. Of course, it’s important to remember that many charitable funds are designed to go on for hundreds of years. A 2% withdrawal rate requires saving up 50 years’ worth of expenses. Unless you are going to live for well over 50 more years, chances are you won’t need this much.

As you can see from the range here, the 4% ‘rule’ is really just a rule of thumb – it’s certainly not a guarantee of safety.

What if I want to work out a different percentage?

Simply divide 100 by the number, e.g. for a 6% safe withdrawal rate, divide 100 by 6: 100/6 = 16.7

Then, multiply your annual expenses by this sum.

The number you multiply by is the number of years’ worth of expenses you need to save up. So if you use a safe withdrawal rate of 4%, you will need 25 years’ worth of expenses saved up.

Which percentage should I pick?

There are a number of factors which will influence which percentage is right for you:

  • If you are nearing traditional retirement age, you may be able to use some of the capital you amass, or you may be just looking for a sum to tide you over until your superannuation or pension kicks in, in which case, a higher percentage may be ‘safe’ for you.
  • If you are young and looking to retire as soon as possible, and are adamant that you don’t want to work again, a lower percentage will probably be necessary.
  • If you are looking to escape from your current job and are happy to have a reduced lifestyle, and possibly pick up part-time work later, a higher percentage may be ‘safe’ for you.

And so on.

But what if things go wrong?

Here is where the ingenuity of the Your Money or Your Life plan kicks in. Joe Dominguez and Vicki Robin outline a plan for Financial Independence which has three pillars:

  • Capital The sum that is invested, ultimately producing at least as much income as your expenses. This is the amount we’ve been discussing so far.
  • Cushion A cash reserve that is enough to cover your expenses for six months.
  • Cache Additional savings beyond core capital or cushion. This is the surplus that results from your expenses decreasing as you no longer have to work, continuing your frugal lifestyle, having the time to carefully research purchases, having a lower tax bill, and any incidental income you earn from hobbies etc.

15FinTake a look at the Can I Retire Yet roadmap

What’s your magic number?

In the next post, we’ll look at how you can get there.

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