What’s Your Financial Independence Number?
What’s your financial independence number?
Most in the financial world prefer to describe this vague sum as a retirement number, but as we’ve discussed before, the concept of retirement often carries a negative connotation that I would rather avoid. Our goal at FYI is to achieve financial independence in order to move on to more important life tasks, not simply retire to the golf course or couch. That being said, let’s not be swept off topic by the semantics of the wording.
How much money do you need to exit the rat race and live the life you’ve envisioned?
This is not a new topic, hence the various formulas constructed to arrive at your golden egg total. The standard financial advice is that you need to be able to replace anywhere from 70-85 percent of your preretirement income after you reach financial independence. That’s not due to reduced spending, but rather the removal of hefty payroll taxes along with retirement savings and work expenses. Using that rational, Fidelity recommends hitting certain savings benchmarks throughout your lifetime, such as saving an amount equal to your household salary by the time you reach 35 and saving three times that amount by 45. Aon Hewitt, which tracks 401(k) trading activities, recommends reaching 11 times your salary by retirement age.
Rules of thumb are beneficial for the masses, but not for individuals. Those suggestions are useful only if you graduated college at 22, make a consistently average salary and plan to retire at 65. Those suggestions are worthless if you attended postgraduate school, started your career later in life, or plan to reach financial independence long before the accepted retirement age. In order to determine your specific financial independence number, you actually need to determine two other variables first: yearly expenses and length of time remaining. The former, while difficult, is possible to calculate with some forward-thinking budgeting. The latter, however, is a different story. The next person to accurately judge how long certain individuals will walk this Earth will be the first, so determining a precise financial independence number is out of the question. Our only option is to take a bookends approach in finding a healthy range in which to aim.
In order to accomplish that goal, it’s imperative to understand safe withdrawal rates. The Bogleheads define it as “the quantity of money, expressed as a percentage of the initial investment, which can be withdrawn per year for a given quantity of time, including adjustments for inflation, and not lead to portfolio failure; failure being defined as a 95% probability of depletion to zero at any time within the specified period.”
In other words, a safe withdrawal rate is the percentage you can pull from your nest egg each year without ever running out of money. The challenge, according to The American College’s retirement guru Wade Pfau, is that “sustainable spending rates depend on future market returns.” And while economists spend their days attempting to provide clarity for the coming decades, it’s little more than an educated guess. Current expected market returns hover in the seven percent range, which nets a four percent real return when you factor in inflation.
Taking the numerous variables into account, three professors at Trinity University back in 1998 concluded that a four percent safe withdrawal rate was sufficient in the first year of retirement in a portfolio containing a mix of stocks and bonds with the assumption that each subsequent year’s withdrawal would increase with the consumer price index for cost of living purposes. At the time of the study, the professors suggested that a four percent safe withdrawal rate would likely never be exhausted over the course of a typical 30-year retirement period.
Due to the market turbulence of the last 17 years, however, Pfau has suggested cutting that four percent withdrawal rate nearly in half (2.1) when using a 40 percent stock allocation plan paired with a 30-year retirement horizon.
Fortunately, there are various online calculators that do the math for us. FIRECalc allows for sophisticated data entry to fine tune your financials while also providing a basic calculation for those of us not interested in the details. For example, if we enter $36,000 for our yearly expenses along with a $750,000 portfolio and a 30-year horizon, FIRECalc looks back over 116 possible 30-year periods and finds our totals were successful 75 percent of the time.
The more in-depth formulas allow for Social Security and pension payments to further bolster the strength of your portfolio, which is important for most Americans considering that Vanguard reported the average 401(k) balance in 2014 was $102,682. The median 401(k) value for households making $100,000 or more was roughly $125,000.
If Americans fail to save more, and save quickly, the reduced portfolio totals will require reduced expenses and time horizon expectations in the quest for financial independence. All three variables share equal importance in determining your number.