Don’t worry, you’ll have enough in retirement … with one big proviso
How to calculate your financial freedom number (and why you should)
Do you know the rule of 25? It’s one of the core tenets of the Financial Independence, Retire Early movement – or FIRE – and a useful starting point for mapping out long-term money goals.
Need $200,000 a year? You’ll have to have saved and invested $5 million, assuming a 60-40 portfolio and drawing down 4 per cent a year. Bethany Rae
When clients walk through Sally Huynh’s door and say they want to retire early, her immediate response is always: why? It’s the three-letter weapon in her financial advice arsenal guaranteed to get clients thinking about what truly makes them happy. Sometimes, people discover that what they really want is to work fewer days or switch careers rather than exiting the workforce entirely.
Huynh, a private wealth adviser with Shadforth in Brisbane, then urges clients to get really specific about their goals. If semi-retirement or retiring early really is the aim, how much money do you need to derive a passive income that meets your desired lifestyle? In millennial parlance, that’s your financial freedom or financial independence number.
Need $200,000 a year? You’ll have to have saved and invested $5 million, assuming a 60-40 portfolio and drawing down 4 per cent a year. Huynh says: “Is a financial freedom number the solution to everything? Probably not, but I see it as a good starting point.”
Financial freedom means different things to different people, says Morningstar director of personal finance Mark LaMonica. “But essentially, it’s this: if you wanted to walk away from your current job tomorrow and be able to support yourself for the rest of your life, how much do you need?”
People have, of course, always longed for financial independence. But the idea that it could be achieved earlier in life by radically minimising expenses and investing the savings in the sharemarket (usually via low-cost index funds), with the ultimate aim being having enough to derive a passive income has come to be known as the FIRE (financial independence, retire early) movement.
Proponents credit the 1992 book Your Money or Your Life by Vicki Robin and Joe Dominguez with bringing FIRE to prominence. Followers are typically millennials (born between 1981 and 1995).
As the FIRE movement continues to grow, the idea that a person can identify a single sum they need to accrue to be financially “free” has also increased in popularity.
Even if you don’t buy into the FIRE hype, read on because it is based on some sound financial planning fundamentals including goal setting, debt minimisation, living within your means and sensible investing.
Calculating your freedom number
Huynh says doing the maths is pretty simple. For the above $200,000 example, it’s a case of multiplying the desired income ($200,000) by 25 (to reach $5 million). The idea is that by drawing down 4 per cent a year – provided nothing goes terribly wrong with the markets – your invested balance should continue growing above the amount you’re withdrawing to fund your expenses.
There is, of course, more to the story. Truly achieving FIRE requires a big income and a lot of dedication, Huynh says. “The reality is wealth creation is really simple, but it’s not easy.”
Brenton Tong, financial adviser at Financial Spectrum, says while FIRE is possible, the reality is that making it happen in Sydney where accommodation – the biggest factor in any FIRE calculation – is so expensive, can make it difficult.
“You have to live a really frugal lifestyle before and after achieving the goal, or seriously increase your earning capacity, neither of which is easy,” he says.
As noted earlier, being clear about the “why” is key. Huynh recalls how two clients, after working hard to achieve FIRE – and coming into a windfall along the way – tapped out of paid work in their early 40s and had kids.
Then they had second thoughts. “Now what they’re saying is, ‘Well, actually, we don’t want to raise kids this way. We don’t want them to see us not going to work.’”
Financial planner Brenton Tong says the frugality required to achieve FIRE can be challenging.
Huynh says the couple has since returned to part-time work to model the benefits of employment, contributing to the community and living a purposeful life.
Strict FIRE is defined by frugality and extreme savings to free up money for investing. Many FIRE adherents explore side hustles, freelance work or other business ventures to supplement their primary income.
Nick Nicolaides, the founder of investment app Pearler, says the concept has significant cache with young people. “It’s more topical than ever because people are feeling really nervous about working their entire life and not having this comfortable position to look forward to,” he says. “Whether that’s having to rent forever or work forever, people are feeling nervous, and it’s pushing them to research.”
In an often-cited study, Gail Matthews, a psychology professor at the Dominican University of California found that when people wrote down their goals, they became 42 per cent more likely to achieve them.
That’s why being specific is key, Nicolaides says. “It’s got to keep you dedicated over the 10, 20 or 30 years [it takes to invest]. So it’s got to be something positive and actionable,” he says.
“A goal is something that informs the strategy that you’re going to take from an investment standpoint, and it inspires you to keep saving,” adds LaMonica. “And really, some of the hardest things about personal finance are time and consistency.”
Morningstar’s Mark LaMonica says a goal is something that informs the investment strategy. Louie Douvis
LaMonica has two numbers. The first is what he calls his survival number, which is the amount that he would need to cover basic living expenses such as food and housing. It’s bare-bones stuff. Then he has his ideal number, which includes more discretionary spending and travel.
La Monica says he has already hit his survival number, and it means he’s been able to make trade-offs between doing the work he really enjoys and potentially being paid more but having to work longer hours in a job he doesn’t like as much.
Tong says when he asks new clients when they want to retire many answer “ASAP”. But he has seen plenty of people retire early and then realise they are bored. “We put retirement on this pedestal, but if you were to ask people, ‘Why is retiring early such a big thing for you?’ a lot wouldn’t be able to give a clear reason why.
“You know when you meet a group of people and somebody asks, ‘What do you do?’ Think about how you’ll answer. You need purpose, meaning, all of those things.”
Tong encourages his clients – especially those in their 30s – to instead aim for a “pressure off” number that allows them to feel like their finances are under control while giving them more choice about how they spend their money.
Huynh uses a six-pronged approach to help clients find their goals. She asks them to think about their family, their career aspirations, their home, their lifestyle, their health and their legacy. She asks:
“We spend a good chunk of time going through those questions to get an idea of who they are and where they see themselves heading. They might not know the answer, and that’s OK, but it’s about helping them think.”
Huynh says many people who claim they want to retire early go through this process and realise the notion is more complicated than it first seems.
“Additionally, $3.8 million will appear daunting or unreachable for someone wanting to retire in their 30s, so a better way to think is instead of retiring completely, continuing to work but at a reduced capacity,” she says.
“Let the accumulated capital build up and add regular smaller savings to it. This will add up over time, so instead of thinking FIRE perhaps FIBC is a better concept – Financial Independence with Better Choices.”
One of the most popular methods used to derive the FI number is to take your annual expenses, or desired annual expenses, and then multiply that by 25. That gives a number from which, theoretically, you should be able to draw down 4 per cent in the first year after retiring, and then withdraw the same dollar amount, adjusted for inflation, every year thereafter.
Proponents of FIRE search for a financial freedom number. Simon Letch
As an example, if someone wants to spend $100,000 a year, the capital they need is $2.5 million (4 per cent of $2.5 million is $100,000). This assumes your investments are earning 4 per cent or more a year.
Young people in particular should take care when aiming for a single, static figure because there is so much of the future that is unknowable, Huynh says. “For someone in their 40s, I’ll get them [to] work out that number they need and then add at least 50 per cent on top, to be conservative,” she says. That takes our hypothetical financial freedom number to $3.8 million.
Delta Financial Group founder Mike Sikar prefers to use a different rule of thumb. His clients are typically in their 50s with household incomes of $500,000. His starting point is that clients will generally need about 70 per cent of their pre-retirement take-home pay to maintain a similar lifestyle in retirement. This is assuming they won’t have a mortgage or school fees to worry about any more, and can save on things such as income protection insurance.
“I’ve done a lot of research into it, and 70 per cent seems to be the common number,” Sikar says. “You’re beginning with the end in mind, and once you understand that, it’s easier to formulate the investments and trajectory of the asset base, in terms of how fast and how big it needs to get to.”
The reality is that building a significant investment sum from which to derive passive income – whether you retire early or otherwise – is very difficult unless you have good earning capacity, Huynh says.
It’s for this reason she believes people in their 30s and 40s ought to remember the power of getting a well-paying job and keeping a sharp eye on cash flow.
Sikar agrees. Given younger investors face more uncertainty around future expenses, to some extent, the most helpful framework is to focus on growing both income and asset base as much as possible.
“It’s your assets that will eventually get you out of the rat race,” he says. “[But] the best thing people can do is enjoy what you do – you’ve got to build your career, and do the best with what you have.”
