Hey, let’s have some fun with maths, right guys? Guys? GUYS?1 [Cue stampede for the exits].
Okay, so previously I laid out my plan for becoming financially independent (FI) in ten years. Literally ‘some’ people said it would be useful to fill in that sketch with numbers, so let’s do it.
It’s not hard to figure out your own plan for financial independence. You only need to know a few figures, and the only one that takes much time to fathom is your required annual income – a.k.a. how much will you need to live on?
Annual income required
1. How much do you live on now? The ideal way to laser this number is by tracking your current monthly expenses on a spreadsheet for a year or so. By that point you’ll have captured most of the annual expenses that parachute into our lives like enemy commandos behind the lines.
If that’s all too much of a fag – or a traumatising journey into your own heart of darkness – then try an online budget planner. You’ll rustle up a workable number in no time.
Now for the fun bit. Let’s imagine how that number might look once you no longer answer to The Man.
2. Subtract expenses that will no longer apply. For starters you can gleefully strike out all your work-related costs – commuting, work clothes, professional fees, expensive lunches, the lot.
Also eliminate expenses that won’t apply once you’re FI. Mortgage payments, sprog fees, saving to be FI and the like can all go.
3. Add new lifestyle expenses. Most people find they live on much less once FI but it’s worth considering a range of categories that begin with H: holidays, hobbies, heating, health, and helium (or is that just me?).
The number you’ll be left with is a rough gauge of the net income you’ll need. Obviously it’s not the real number – you’ll only know that once you arrive in the future – but it will do for now.
Also, don’t worry about inflation. Later we’ll use calculators that take inflation into account, so we can keep working in today’s figures. Praise be.
4. Don’t forget tax. As if you would. To turn net income into gross income, just dial up your favourite tax calculator. For sheer simplicity I like iknowtax.com.
Pop in your net income figure as your salary (into the calculator) and you’ll see what you’re left with once your tax bill is chopped off. Play around with the salary figure until you can take home the net income you need. Et voila! The salary figure is the gross income you need to work with.
Remember to cancel out the effect of National Insurance Contributions, as you won’t be paying any if you’re not employed.
Bear in mind that income drawn from an ISA is not subject to income tax, but you do pay tax on pension monies over and above your personal allowance.
5. Subtract other expected income. Expect to have income coming in from elsewhere? Then you won’t need to amass quite as big a mountain of assets to generate your income for you. Obviously these other income sources only count if they can be relied upon, and if they’re on stream by the time you achieve FI.
Common conduits of regular cash include:
- State Pension
- Defined Benefit pension
- State benefits
- Part-time work
- Other passive income – trust payments, royalties, and so on.
Still with us? Having dashed through those five steps you’ll have a good enough idea of the gross income you will need to live on from your investments. Once your assets can support that income then you can declare yourself FI.
Cut a ribbon, run a flag up a pole, fire AK-47s into the air – whatever floats your boat.
Your target asset pile
To generate your desired income from your investments, you’ll need to accumulate a large heap of capital. How big should it be?
To find out, all you need do is divide your income by your withdrawal rate.
Your withdrawal rate is the set percentage that you cream off from your hoard as income.
- If your required annual income = £20,000
- And your withdrawal rate = 4%
- Then your target to achieve FI = £20,000/0.04 = £500,000
You’ll need to accumulate £500,000 to earn an annual income of £20,000 at a 4% withdrawal rate in this scenario.
£500,000 = Financial independence in this scenario
I need to write a post or three on withdrawal rates. A few things to know:
- The withdrawal rate is the amount you take in year one of your financial independence. You adjust your income in line with inflation every year after that.
- If you withdraw too much then you’ll shrink your hoard faster than it can replenish itself with interest, dividends, and capital gains. Live like Tamara Ecclestone for a few years and you’ll be running on empty with bills to pay.
- 4% is a financial industry standard for a safe withdrawal rate. According to widely accepted practice, you can set your withdrawal rate at 4% a year and have very little chance of ever running down your entire hoard to zero.
- What’s less well known is that the 4% rule was derived from a specific set of assumptions that applied largely to the US, and to retirements lasting 30 years or less.
- 3% is emerging as a far safer yet still achievable withdrawal rate, although research is ongoing. Rummage through Professor Wade Pfau’s blog for more.
Hitting your target comes down to how much you can save and the returns you earn on your investments.
Your savings rate is absolutely critical. This is the master string that makes the rest of your financial puppet dance.
It doesn’t matter how big your salary is or how much you live on, your savings rate dictates how long you will spend working. The following table – sampled from Mr Money Mustache’s excellent post that underlines this point in red pen – shows you how quickly you can go from zero to ‘cheerio’2:
|Savings rate||Years to FI|
It’s a beautiful relationship. If you can save more now, then you have proved you can live on less, which means your income target is smaller and you will reach it sooner.
So what’s your savings rate?
For the purposes of our calculation, we’re interested in the actual amount you can tuck away monthly.
You probably know this number already, but just to make sure you’re getting as full a figure as possible:
- Take your annual net income
- Subtract your annual expenses
- Add all your other income streams including rentals and bank interest
- Add pension contributions and employer matches if pensions are a factor in your plan. Gross them up to account for tax relief.
- Don’t add investment income and gains. These are accounted for in the return assumptions that follow.
The number you’re left with is how much you should be saving a year. Now take your total savings and perform the following calculation as provided by UK early retirement blogger The Firestarter:
Total Savings3 / ( Total Savings + Expenses ) x 100 = Your savings rate
Once you know your savings rate you know how long it will be until you retire. Ratchet up the rate if you want out quicker.
Picking a return rate
This is the final piece of the puzzle – the return that swells your investments into your own financial life support system.
However you calculate it, this number will be wrong. If I (or anybody else) knew what the market is going to deliver over the next couple of decades then I wouldn’t be writing this blog post. I’d be flicking through What Tropical Island? magazine.
You could just use whatever rate is inserted by default into an online calculator, but be aware that these numbers are usually pretty generous. After all, companies know you’re more likely to use their products if they deliver good news.
A 4% real rate of return4 is a common gambit. That comes from a 5% historical real rate of return for UK equities and 2% for government bonds. It also assumes you’ll plump for a 60:40 equity-bonds portfolio.
Tim Hale – in his superb book Smarter Investing – suggested that you’ve got a 55% chance of doing better than 4% over 20 years in a 60:40 portfolio, and a 70% chance of beating 3%. That was before the credit crunch though. Post-2008, many commentators are predicting a long period of slow growth while low interest rates prevail.
Again, even Brian Blessed couldn’t over emphasise what a shot in the dark these numbers are. You also need to dilute to taste. If your portfolio is more like 40:60 equities-bonds then your expected returns rate will be lower. But you can nudge the rate up to historical norms if your time horizon lengthens and your tilt towards equities becomes more daring.
Your best bet is to run a few different scenarios using nightmare and conservative assumptions, especially if your timescale is fewer than 20 years.
I personally wouldn’t run a dream scenario for fear that I’d anchor myself to an unrealistic number. If the future turns out to be a garden of roses then I’ll enjoy that when the time comes!
Don’t get your nominal and real returns mixed up. If your calculator includes an assumption for inflation, then feed in a nominal return that adds that inflation number to your expected real return.
It’s a numbers game
Right, let’s spin the wheel of fortune and see when you’re gonna be FI.
- Feed all your numbers into an investment calculator like this one.
- Strip out the inflation figure from the calculator if you’re feeding in a real expected return. If you want an inflation guesstimate then 3% p.a. is around the UK average. (That ‘slow growth report’ I mentioned assumes 2.5%.)
- The lump sum figure is money you already have. It can include the value of any rental property (minus attached mortgage debt), pension assets (if you can access them), savings accounts, and current investments.
- Don’t include your home, wine cellar, fleet of Vauxhall Corsas and so on.
The result is your answer, in years, to the question: When will I be financially independent?
Don’t like it? Then change something.
Take it steady,
PS – Here’s the article again in fast forward:
- Annual income / Withdrawal rate = FI target
- Take FI target
- + monthly saving figure
- + real return rate assumption
- Feed numbers into calculator
- = Years until you are FI!
- Editor’s note: He means ‘guys’ in the uni-sexual post-Friends era sense. And I won’t let him write ‘gals’ anyway. [↩]
- See Mr Money Mustache’s post for the assumptions. [↩]
- Include all grossed up savings into pension funds along with employer matches [↩]
- The real return is the return you’ll get after stripping out inflation. [↩]
- That portfolio is somewhat more aggressive than 60:40 too [↩]
- If you don’t know that number then you can safely plump for 0.5% if you’ve got a nicely diversified portfolio of index trackers. [↩]