When are you financially independent?
Financial independence comes from two factors– having (1) enough assets to support (2) your expenses. Most of us would prefer to focus on the first factor. We’d like to get our assets by earning a high salary (ideally for very little work), being a brilliant investor, or inheriting a windfall. (Or “Plan D”: winning the lottery.) Unfortunately it can be extraordinarily difficult to rapidly raise your income to build up enough assets to achieve financial independence in a short time. The harsh reality is that materialistic consumers will have to work for decades to gather enough assets to support their expenses.
It’s easier to focus on the second factor by reducing expenses. Notice that it’s “easier” to reduce expenses, not necessarily “painless”. Every hopeful retiree is eventually forced to choose the values that are most important to them: either working for decades to afford an affluent lifestyle with high expenses, or reducing their lifestyle to minimize their working years. You have to find the right work/life balance that’s acceptable to you and your family. You’re frugal if your values match your spending and you’re feeling good about your retirement goals. You’ve crossed the line to deprivation if you’re miserable and stressed out every day, struggling against all sorts of material temptations while trying to pile up enough assets to stop working. Refer to the related posts at the end for more details on drawing the line between frugality and deprivation.
How much will you need?
While some of us will struggle for years with the frugality/deprivation line, others will want to revisit that issue after finding the answer to the next question: how much will you need? For this analysis we’re going to assume that the Trinity Study’s 4% is a safe withdrawal rate. That study assumes you spend 4% of your retirement portfolio during the first year and raise the amount for inflation every succeeding year. Dozens of studies have clustered around SWRs of 2-6% using various assumptions and other complicated withdrawal schemes, but most of the studies agree that 4% is probably safe enough. Most new retirees will boost the “safe enough” assessment to “100% success” by keeping an eye on spending through the retirement years and not blindly raising it every year for inflation. Some will spend 4% of their portfolio every year and never raise it for inflation, while hoping that their portfolio will grow faster than inflation. Others will work for “just one more year” to pad their portfolios with a safety factor. Others might even decide to go back to work for a few months during recessions to help their retirement portfolio recover. (See Bob Clyatt’s “Work Less, Live More” book for another easy-to-use 4%/95% variable spending plan.) The odds of a 4% SWR failure are very low, and for the rest of this post we’re going to assume that you’ll be able to see problems coming soon enough (and slowly enough) to avoid them.
Having trotted out those disclaimers, the math result is that financial independence happens when your assets are equal to your expenses divided by 4%. In other words,
FI: Assets = Expenses / 0.04 = Expenses * 25.
Once your assets are 25x your expenses then you’re financially independent and able to retire at any time. It bears repeating that before you can solve this equation, you have to track your expenses and develop a realistic retirement spending budget.
How long will it take?
Once everyone has determined how much they’ll need, the next question is how quickly they can get there. Again we’re going to focus on reducing expenses (and on saving more money) rather than raising income. Military members will see their pay rise with longevity and promotions, but the forecasts on when that will occur (and for how much money) can rapidly deteriorate into wishful thinking instead of a realistic career timeline. We’ll get back to these pay raise/promotion issues after we look at the math.
Let’s add another simplifying assumption: constant savings. We’ll assume that your income and expenses will remain at about the same ratio for the time it takes you to achieve financial independence. Realistically the time to accumulate enough savings will be a matter of 5-10 years, although a few will take longer. There will probably be at least one pay raise and a promotion during those years, so the assumption makes the savings math a lot easier while keeping a practical forecast.
Let’s start with an extreme case. Jacob Lund Fisker, owner of the EarlyRetirementExtreme.org website, has managed to achieve financial independence through saving as much as 80% of his income. Yes, that’s extreme. But yes, it’s achievable and sustainable if your values include achieving financial independence in your 30s. You’ll have to read his blog (and his book!) to figure out how he did it (and to decide whether you’re willing to do it) but let’s start with that 80% number.
If you earn $1000/year and save 80% of it, or $800/year, that means your expenses are $200/year. Achieving assets of 25 x expenses requires 25 x $200 = $5000. Savings are $800/year, so the time to financial independence is $5000 / ($800/year) = 6.25 years. In the real world those savings would be invested in a balanced portfolio of equities, bonds, and cash that would (over the long term) compound by at least the rate of inflation. Six years of compounding may accelerate the retirement date by a few months but that depends on the portfolio’s specific asset allocation, its volatility, and the annual performance.
At this point most of the readers are probably still stuck a couple paragraphs back at that 80% savings rate. Maybe 80% is too extreme to be realistic for most. Let’s try a number at the other end of the bell curve.
Most financial advisers (and the popular financial media) encourage new investors to save at least 15% of their income. The assumption is that a new worker, fresh out of school and starting an independent life, will struggle to save even 15% of their income as they accumulate a wardrobe of office attire, transportation, living quarters, and furnishings (let alone a family). Another assumption behind the 15% sound bite is that a worker’s savings rate will accelerate as their income rises with their careers, and they’ll save a much higher percentage of their income when they’re in their 50s and 60s. The 15% number is chosen by the media to encourage their young readers while admonishing them to save more as soon as they’re able.
Unfortunately a 15% savings rate means they’re going to be working a long time. Saving $150/year with expenses of $850/year means that assets = 25 x $850 = $21,250. Time to financial independence becomes $21,250 / ($150/year) = 142 years. That can’t be right, can it?
Luckily the actual answer turns out to be “only” 43 years. The reason for the difference is that each previous year’s savings is compounding as a new year’s savings is added to the portfolio. The 80% saver was only saving for six years, and compounding wasn’t a very significant factor during that short time period. For the 15% saver, over their decades of working years the compounding becomes significant enough that the portfolio begins to grow exponentially. Notice, however, that 43 years is also the amount of time that most people will be in the workforce to retire in their 60s.
Before we bring out the math and the results tables, let’s review the simplifying assumptions behind the numbers:
- A constant savings rate, even though most military will have longevity pay raises and promotions along with occasional periods of tax-free combat pay. Bonuses are, well, just bonus!
- A single income earner, although a working spouse can greatly improve the savings rate.
- Constant expenses, even though expenses can vary from one year to the next and will generally drop as frugality skills improve. Expenses in a combat zone are even lower because that’s deprivation.
- A conservative rate of return of 5-6% per year, even though investment allocations will be in a high-equity portfolio (stock index funds) with very low expenses (the TSP).
- A safe withdrawal rate of 4% rising every year for inflation, even though a recession would cause most retirees to cut spending or work part time.
- No pension, no Social Security, no Medicare. This calculation assumes that you’re doing it all on your own investments and your own health insurance. I’m not going to get into the politics but I’ll confidently forecast that some form of Social Security and Medicare will still be making a difference even for those readers who are currently teenagers.
The math behind the savings and compounding is a more complicated exponential formula for determining the future value of a series of payments:
Assets = Expenses * 25
= (Savings rate) * [(1 + compounding rate)^^Time - 1] / (compounding rate)
The compounding rate is the rate of return on the investment portfolio. A realistic value is about 5%-6%/year depending on the asset allocation and the length of time that the assets are invested. (One version of this assumption is called the “Gordon Equation“.) Assuming a 5%-6% compounding rate means that the equation can be solved for the length of time required for various savings rates. I’m going to put the math in a footnote and go straight to the tables:
Years to Financial Independence at a 5% rate of return for various savings rates:
|Savings rate (%):||Years to FI:|
Years to Financial Independence at a 6% rate of return for various savings rates:
|Savings rate (%):||Years to FI:|
Alert readers of this blog will notice I’ve been claiming that financial independence comes in 5-10 years to most military members, with some needing a little longer. Even a 40% savings rate is within the length of a military career, and that career will be followed by an inflation-adjusted military pension with cheap healthcare. In other words, the pension will cover a significant percentage of retiree expenses and will dramatically drop the necessary size of the portfolio to cover remaining expenses. A 20-year military career is a slam-dunk for financial independence– when saving starts early in the career.
More aggressive 60-70% savings rates, especially with a working spouse, will cut the time to financial independence to a decade even without a pay raise. Servicemembers are earning annual pay raises, longevity pay raises, promotions, and several other boosts to their income. Even as few as two service obligations (a total of 8-12 years) will see significant pay increases as well as large savings rates during deployments.
Three other factors are working in your favor: Social Security, investment returns, and your retirement budget. All of these factors used very conservative assumptions to generate the results tables. The reality is that you’ll have years with higher returns, and your retirement expenses will also vary from one year to the next. A conservative retirement budget (and the ability to play extraordinarily frugal defense if necessary) will give you plenty of safety to enjoy your retirement years.
Next post: are you really willing to be frugal enough to achieve these savings rates?!?
Expenses * 25 =
= (Savings rate) * [(1 + compounding rate)^^Time - 1] / (compounding rate)
Rearrange the terms to get:
(1 + compounding rate)^^Time = (Expenses * 25 * compounding rate / savings rate) + 1
Taking the natural logarithm of both sides gives
= ln[(Expenses * 25 * compounding rate / savings rate) + 1] / ln(1 + compounding rate)
Solving for time (years) assumes that the compounding rate is an annual percentage yield expressed as 5% (use the calculator’s % key) or 0.05. Expenses and savings can be in percentages of total income or in dollars per year.
4 July 2011 update: Thanks to Arebelspy on Early-Retirement.org, I’ve uploaded v1.0 of the quick & dirty spreadsheet to calculate your own assumed savings rates and returns. Save this Google file to your own computer and tweak away, or download from the following link: Time to Financial Independence and Retirement And please share your improvements with us!
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By the way, I’ve joined the WordPress 2011 commitment to “PostAWeek”… to blogging at least once a week for the rest of the year. Every day is too frequently, Mon/Wed/Thu is about right, and once a week will be no problem!