July is the month that we gather with family and friends over barbecue and fireworks to celebrate our nation’s independence. This month, take a moment to consider your own financial independence.
What is financial independence?
Financial independence is a concept that means something different to everyone. To some, it is being able to buy a house or send your kids to college. To others, it is simply getting out of debt. To me, you are financially independent when you have adequate resources to cover all of your current and future expenses. This includes your basic necessities and lifestyle expenses, as well as discretionary/luxury expenses. This includes any one-time or non-recurring expenses, such as travel, education or charitable giving goals. You have to also account for inflation, and possible future expenses such as health care or long term care expenses.
To put it more simply, financial independence is when you have enough money and/or income that you can live the life that you want without ever having to work for an income.
Most often, we think of this as retirement, which traditionally happens in your mid-sixties when a combination of Social Security, pension income and retirement savings allows you to comfortably leave the workforce. This is also an aspiration among younger people, often seeking to leave a demanding career in order to live more simply, spend time with a growing family, or seek more fulfilling, but less lucrative pursuits.
What’s your number?
No, this isn’t a cheesy pick-up line at a singles bar. “Your number” is the total amount that you’ll need to save and invest to cover your future lifetime expenses. Of course, the further away from retirement that you are today, the more difficult this is to calculate. Expenses, lifestyle, needs, health care costs will not be the same in the future as it is today. The only constant, as they say, is change. But in the absence of a crystal ball, the best starting point to calculate your future expenses is to begin with your current expenses, adding in known changes, such as college education or a planned relocation.
After you have calculated your future expenses, you can subtract any expected income such as Social Security or pension. The result of the total amount that you will need to self fund through your savings and investment. This is where we get to your number.
There is much debate among economists, financial planners, and academia regarding what we consider a “safe withdrawal rate,” which is a critical concept in calculating your number. Basically, the safe withdrawal rate (SWR) is the percent of your investment portfolio that you can withdraw in year one, allowing you to increase that withdrawal for inflation over your lifetime, and remain confident that you will not run out of money.
A number of factors play into the calculation of your SWR, including your age at retirement, expected longevity, and how your money is invested. For our purposes here, we’ll use a SWR of 5%.
From here, you can calculate your number by dividing the total amount of your expenses that will be self funded by the SWR of 5%. Here it is in a formula:
[(Total annual expenses)-(Retirement income, such as Social Security)]/(SWR)
Putting some numbers to it, let’s say your total annual expenses are $80,000, you expect to receive $25,000 in Social Security, and we’re going with a SWR of 5%. Then, your number equals:
($80,000-$25,000)/5% = $1,100,000
As you can see, your number is likely to be quite substantial, which is why it typically takes a lifetime of working and saving to achieve it.
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Maintaining financial independence
It’s important to remember that achieving financial independence does not guarantee that you will remain independent for life. How many times have we heard about the professional athlete or lottery winner who has more money than most people will make in multiple lifetimes, only to blow through it in an expensive lifestyle, excessive gifts, and bad business deals? Or the retiree who worked hard and saved diligently, only to fall prey to a swindler like Bernie Madoff, or through a series of poor investment choices, find themselves in a precarious position.
The key to maintaining financial independence is to have a sound plan and stick to it. Here are several elements to the plan and helpful tips to help you stick to it:
- Monitor your withdrawal rate and implement rules to keep the rate from getting too high or too low.
- Maintain a separate discretionary “bucket” which allows you to access additional funds for one-time or unexpected expenses without increasing your portfolio withdrawal rate in an ad hoc manner.
- Implement a proper asset allocation that allows for adequate portfolio growth to keep up with lifetime inflation, but also with enough conservative assets to withstand any market downturns.
- Manage your costs; one of the biggest costs to be managed in retirement is taxes. Make sure you are looking at tax liabilities into the future and how social security, required minimum distributions and other tax surcharges will affect you through retirement.
- If you work with a financial advisor, make sure that they are a fiduciary, which means that they are legally required to put your interests ahead of their own.
- Develop a plan that allows you to continue the cash flow that you need through all market conditions.
- Plan ahead for expected changes in spending such as rising health care costs, paying off a mortgage, or launching a child into independence (even if only partially).
Managing your financial independence is not a “set it and forget it” endeavor. Maintaining the balance between maximizing your lifestyle and securing the sustainability of your financial future requires ongoing monitoring and assessment of what is truly most important to you.