Financial independence is one of the most enticing phrases in the personal finance lexicon. For some people financial independence means escaping a paycheck to paycheck cycle. Others think of it being fabulously wealthy and owning yachts on the Riviera. While each definition is valid in its own way, this article focuses on financial independence for retirement.
As it relates to retirement, Financial Independence (FI) is having enough money or passive cash flow to cover all reasonable expenses for the rest of your life. Retirees who achieve financial independence before retiring don’t need to worry about returning to work. Their passive income and assets will cover all reasonable expenses for the rest of their life.
If you’re approaching a traditional (or even an early) retirement age, its worth checking whether you’re also approaching your Financial Independence number. Or more accurately, your financial independence numbers. We cover the six most important numbers to track to ensure you hit financial independence before retiring.
The FI Number
The basic FI Number shows whether you have enough saved to retire. To calculate it, you need to know your annual expenses (which can be found through the Retirement Budget Calculator).
Once you know your annual expenses, you need to compare it to your assets.
When your guaranteed annual income sources (Social Security, Pension, Rental Income) and 3.5% of your investment portfolio are greater than your annual expenses, you are financially independent.
The 3.5% of assets is considered a conservative or “safe” withdrawal rate for someone who expects to need to live off their assets for at least 30 years.
Let’s say a couple has expenses of $90,000 per year. When they turn 62, they expect to have the following guaranteed income sources in retirement:
- Wife Social Security: $2000 per month, $24,000 per year
- Husband Social Security: $1300 per month, $15,600 per year in
- Husband Pension: $500 per month, $6,000 per year
- Paid of rental properties: $2000 per month $24,000 per year
In total, they have $67,600 in Guaranteed Income. On top of this, the couple has $400,000 in retirement savings accounts. 3.5% of $400,000 is $14,000 per year.
Their FI Number is:
$67,600 in income + $14,000 in safe withdrawals = $81,600 in total income.
Total spending ($90,000) - expected retirement income ($81,6000) = -$8,400.
According to this formula, the couple has a gap of $8,400 per year to cover before hitting financial independence. To formally hit FI before retirement, the couple can lower expenses or increase their savings. Playing with the numbers in the retirement budget calculator can help them decide which makes more sense.
“Safe” Withdrawal Ratio
During retirement, a portion of retiree’s spending will be covered by guaranteed income. The other part will be covered by withdrawing from a portfolio. During the first several years of retirement, financial planners typically advise retirees to have withdrawal rates ranging from 3-4% of their portfolio annually. This is considered a “safe” withdrawal rate. When they withdraw at this rate, retirees are unlikely to run out of money during a 30 year retirement assuming a 60/40 stock bond asset allocation.
The retirement budget calculator helps users calculate their withdrawal ratio. Ideally, users will want to keep this ratio below 4% for most of their retirement. However, this ratio is especially important during the early years of retirement, when retirees have longer to live and therefore need their portfolio to last longer.
Retirement Savings Ratio
Closely related to the financial independence number is the “retirement savings ratio”. This number tells you how much more you need to save to reach financial independence before retirement.
The retirement savings number can be calculated as follows:
Annual essential expenses – annual guaranteed income = annual portfolio withdrawals.
Portfolio withdrawals are the amount you will withdraw from your portfolio each year. Multiplying the annual withdrawals by 25 to 33 gives you the nest egg you need to retire.
The couple in the example above has $67,600 in “Guaranteed Income” each year of retirement. But they spend $90,000 per year.
The couple needs to withdraw $22,400 per year ($90,000-$67,600). For a 4% annual withdrawal rate, they need a portfolio with $560,000 ($22,400 X 25). If they want a more conservative 3% withdrawal rate, they need $745,920 ($22,400 X 33.3).
Millionaire Next Door Formula
A related formula is the Millionaire Next Door Formula. This formula doesn’t track retirement readiness or financial independence. Instead, it shows your likelihood of becoming a “Millionaire Next Door”.
This formula suggests that you should multiply your current annual income by your age. Divide that by 10. The number remaining is a good target for your nest egg.
A couple with an average age of 58 has a household income of $150,000. 58 X $150,000= $8,700,000. Divided by 10 leaves them with a target net worth of $870,000.
Ideally, this couple will have a nest egg with at least $870,000 in it by age 58.
If you’re “behind” according to this goal don’t despair. Many people face lower incomes and higher expenses during their 30s and 40s when they have children in the home. Others experience unsuccessful businesses for several years before they start a better earning trajectory. Your fifties and sixties are an excellent opportunity to strengthen earning potential and boost investment rates.
Sound Retirement Income Score
While the financial independence number provides a technical angle to retirement readiness, but its not the only angle to consider. Retirees will also want to consider how comfortable they feel spending money during retirement. Many people are more comfortable spending income (from Social Security, Pensions, and possibly rental properties) than selling assets to cover their regular expenses during retirement.
The Sound Retirement Income Score takes this into account. The Sound Retirement Income Score divides your income from guaranteed sources by your essential expenses during retirement. The retirement budget calculator actually looks over the decades of your intended retirement to come up with this calculation.
Ideally, retirees will want at least 80% of their essential (non-negotiable) expenses to be covered by guaranteed income. If your sound retirement score is well below the 80% threshold, you may have options to boost it before retirement. For example, paying off your mortgage and all other debts before retirement can lower essential expenses. Retirees with large nest eggs may want to convert a portion of their nest egg to a guaranteed annuity to boost their income.
Debt to Assets Ratio
During the final five to ten years before retirement, it is important to take a look at your total debt picture. Most people want to retire debt-free. Having lots of payments can make it difficult to squeeze in some of the luxuries that will make retirement fun.
While paying off debt before retirement is important, it may be just as important to avoid taking on excessive debt before or during retirement. Big-ticket purchases like a new RV or helping children pay for school may be important to you. But these purchases can be tough on the retirement budget.
If you’re planning to retire soon, work to keep your debt-to-assets ratio below 20%. Your debt is your total debt load. Your assets are all your assets that are invested in either cash or other financial securities like the stock market.
People with higher debt loads may want to downsize or consider working longer to lower their debt.
Are you preparing for financial independence?
Whether you’ve heard the term or not, Financial Independence before retirement is a worthy goal. Achieving financial independence before retirement can help you get the most out of your retirement years. It will allow you to spend less time worrying about finances and more time on living a meaningful life. Start tracking your FI numbers today, so you can retire with more confidence down the road.