Although people often state financial independence as a personal goal, few with whom I’ve spoken can articulate what that means. (And even fewer know precisely how to get there.) It’s a lot easier to work towards an objective, when that objective is precisely defined.
For me, financial independence would require having an invested amount of capital, capable of providing a sufficient annual income, for as long as I live.
So how much is required to achieve financial independence?
There’s a general rule of thumb which states that if you withdraw no more than 3% of your invested capital every year (assuming it’s sensibly invested), then it’s very unlikely you’ll ever exhaust your invested capital.
According to William Bernstein, in “The Investor’s Manifesto”:
My rule of thumb is that if you spend 2 percent of your nest egg per year, adjusted upward for the cost of living, you are secure as possible; at 3 percent, you are probably safe; at 4 percent, you are taking real risks; and at 5 percent, you had better like cat food and vacations very close to home.
For example, if you could live comfortably today, on $100,000 per year, then you would need about $3.3 million dollars of invested capital in order to achieve financial independence. The invested capital should grow sufficiently to cover inflation, such that each year, for as long as you live, you can withdraw enough to preserve the purchasing power of $100,000 today, and never have to worry about exhausting your capital.
So how do you get there?
Given the power of compounding returns, the importance of starting a savings/investment plan early can not be emphasized enough.
Consider two people who begin with no savings — one at age 20, and one at age 30. Both wish to be financially independent with an annual income (in today’s dollars) of $70,000 by age 50. Let’s assume 4% inflation, an 8% annual return on investment, and contributions adjusted annually for inflation. How much would each have to save, annually (and adjusted upward for inflation) to reach that goal?
- The 20 year-old would have to save $40,000 per year.
- The 30 year-old would have to save $75,000 per year, i.e. 87% more each year than the 20 year-old.
Looked at another way, if the 20 year old defers starting his savings/investment plan only 5 years, his required annual contribution (in today’s dollars!) jumps 37% to $55,000.
Again, the power of time (compounding return) is so, so important. If you are young, you need to start saving now.
That would be true if you wanted all your invested capital to be there even after you’re already dead or?
How about a 40 year old which just wants to live off his savings until the end of his life – let’s say with 80?
The math behind these analyses is extremely sensitive to the input parameters (and are more sensitive the younger you are). For example, I think, for a person retiring at around age 65, at a 3% drawdown, the chances of outliving your savings is something like less than 5%. If you increase the drawdown by just one percent, to 4%, the chances of outliving your savings increases to something like 20%.
I’m just going from memory, and the precise numbers are most certainly different from those above, but the general concept is valid — calculating a drawdown in which you plan to exhaust your savings doesn’t result in a drawdown (if you’re relatively young) much more than the drawdown calculated to never exhaust your savings.
And, since the worst thing that could happen is outliving your savings, it wouldn’t therefore make sense to plan drawdown with savings exhaustion as an objective. The additional consumption benefit likely wouldn’t compensate the risk of miscalculation.
This systems fails when you have rising cost of living and low returns on your investments… pretty much like today with yields on the 10 year @2,625 at the same time when low capital order goods are rising pretty fast.
Yes, the system fails if the assumptions don’t hold. But, at least for the US market, the assumption of 4% inflation and 8% return are generally accepted as reasonable values over investment windows of 20 years or more.