Put simply, financial independence is the ability to live in an appropriate level of comfort without having to rely on income from a traditional 9-5 job. Thus you need to have a nest egg that is large enough to support your lifestyle.
FIRE is the ability to reach financial independence before a traditional retirement age such as in your forties or fifties rather than your sixties. However it requires, discipline planning and and at the end of the day a large pot of money.
So, how big does that nest egg need to be?
A general rule of thumb is called the 4% rule. You will find references to this throughout the popular press in the personal finance section. The 4% rule typically states that once retired, if you have a large enough nest egg that you can withdraw 4% each year from that pot there is a high likelihood that this money can support you through a typical 30 year retirement (say 65-95 years old) before running out.
So if you want to live on $50,000 a year you would need $1.25M ($1.25M X 4% = $50,000). So in year one you would draw down $50,000 from your savings, in year two you would adjust upwards by the rate of inflation so that you are still living off the equivalent of $50K, so if inflation was 3%, in year 2 you would need to draw down $51,500. Year three would be $53,045 and so on.
Now of course over those years the pool of money you are drawing from is not remaining static, as it is being replenished by being invested in appropriate vehicles such as stocks and bonds. Hopefully the rate of return is greater than the 4% you are drawing down each year so that it never runs out, however there is no certainty to this, but over 30 years the 4% guideline in most cases should be adequate.
But what if you want to be truly financially independent and quit work at 40 or 50? In that case you don’t want your money to run out after 30 years; ideally you want your money to continue to grow and to fund your retirement in perpetuity. In that case the 4% rule doesn’t in apply. Instead you want to think about a 2.5% or 3% rule. So again to live on $50,000 a year you would need a pool that is $2M in size ($2M X 2.5% = $50,000). Again you would need to adjust annually for inflation, but on average if you can get your money returning more that 2.5% on average annually then the pool of money should never run out. Remember though that on an annual basis your investments may dramatically vary and may go up significantly one year, and down significantly the next, so you need to be in it for the long haul.
I have mentioned several time about drawing down from your nest egg so how do you measure the size of this? The financial term for this is called “net worth” and in broad terms it is the difference between your assets and your debts, so for example your total assets might look like below.
- Savings $500,000
- House Value $400,000
- 401k $300,000
- Car Value $25,000
- Total Assets $1,225,000
On the other side the persons debts might be
- Mortgage $200,000
- Credit Card Debt $10,000
- Total Debts $210,000
In this example the total net worth is $1,015,000 ($1,225,000 – $210,000). This person would therefore not be financially independent (unless they can live on around $25,000 per year).
Knowing your net worth is an important part of understanding whether you can retire or not, either traditionally or early.
Do you know your net worth and how to calculate it?