Financial independence, or: not having to work anymore, might seem unrealistic. I’ll need millions! Before I have that kind of money saved, i’m already at my official retirement age!
Financial independence is a big goal (think 10 to 20 years). But as soon as you understand the two basic concepts, you will be able to calculate what the possibilities are. This in itself provides some form of freedom already: you now know it is possible!
You will have to do some excel work, but in essence all you need are the following two concepts:
- Savings rate = the % of your income that you don’t spend
Or more officially, according to Investopedia:
“A savings rate is the amount of money, expressed as a percentage or ratio, that a person deducts from his disposable personal income to set aside as a nest egg or for retirement”.
- Save withdrawal rate = the % of your savings you can safely spend
or more officially, according to Investopedia:
“The safe withdrawal rate (SWR) method is one way that retirees can determine how much money they can withdraw from their accounts each year without running out of money before reaching the end of their lives”
Let’s explore these two concepts a little further:
The more you can save and set aside, the faster you can build up the capital required for financial independence. The Safe Withdrawal Rate determines how much capital you need.
In order to increase your savings rate you can either increase your income or decrease your spending. The easiest of these two options is decreasing your spending. If you are in the beginning of your career (in your twenties, or beginning thirties), you can expect some pay rise while you gain more experience, although this is uncertain.
Getting a higher salary will become harder when you get older. Research in the Netherlands shows that most people reach the peak of their income around age 40. Therefore the easiest, most effective option for increasing your savings rate is lowering your expenses.
Cutting your expenses has two advantages: while in the beginning of your journey to financial freedom, it helps to increase your savings rate. Additionally, if you get used to spending less money, you will also need less money at the moment you have reached financial independence. This is therefore a very efficient action.
Save Withdrawal Rate
In 1994, William P. Bengen concluded that a 4% withdrawal is generally save. His conclusions are based on historical data, including worst case scenarios, such as the great depression and 1973-1974 crisis.
Later research shows that an initial 4,5% withdrawal rate, has a 96% probability of leaving more than 100% of the original capital. A 3,5% withdrawal rate will basically keep the capital intact forever. These rates are not based on long term averages, but on worst case scenarios seen in history.
For simplicity sake, I will stick to the 4% as a basic rule. You can get a closer look at Safe Withdrawal Rate in this post.
If you need EUR 4000,- per month (or EUR 48K per year). Your capital needs to be
48K / 0,04 = 1.200.000 EUR
If you can live with EUR 3000,- per month (or EUR 36K per year), your capital needs to be 900.000.
Another way to calculate your initial capitial is multiplying your required spending by 25 (using the 4% SWR):
Yearly Spend x 25 = Capital for Financial Freedom
The effect of lowering required cost of living
Using one scenario, this graph, shows what the effect is of lowering your yearly cost of living on the moment you can reach financial freedom. When you are able to live with less money, the financial freedom age approach rapidly.
The effect of the Safe Withdrawal Rate
This chart shows what the impact is of using different Safe Withdrawal Rates, on the financial freedom age. Using a very safe 2% rather then 4% will increase my financial freedom age to 80 instead of 55!
Play around with savings rate and Safe Withdrawal Rate, and see when you can reach financial freedom!
Photo by Fabian Blank on Unsplash