Financial Independence is all the rage in the personal finance blog sphere. I myself have routinely stated it should be one of everyone’s goals. In the past I have even commented rather cryptically that we are financially independent in at least a base sense. But what do I mean? Are we Financially Independent?
Mainstream Definition of Financial Independence
The mainstream definition of financial independence seems to focus on the number of years of income you have saved. I am not sure why because in my experience income has little correlation to your actual bills. What does it matter how much your income is if you can or cannot pay your bills from year to year? Isn’t a requirement of your wealth being self sustaining that it produces more than it expends?
Not only that, in my personal case our household income has been highly volatile. If we used income as a measurement of if we are financially independent the results would change drastically each year. For example is our income measured before or after my wife became a stay at home mom? Is it measured in a year where the market is up so my RSUs do well, or a year like 2008? Measuring Net Worth by itself is variable enough without the target fluctuating as well. So I will not be measuring my wealth as a percentage of income for the determination of financial independence.
The 4% Rule and Financial Independence
A better definition of financial independence, more widely accepted by the personal finance community, is based on expenses. This makes much more sense as expenses are generally fairly constant year on year. They also have some basis in reality since expenses are tied to well…. your use of the money rather then what you earn. You do not need to replace your income to live, you do have to pay your bills.
The most popular target for financial independence or retirement is the 4% rule. The 4 percent rule basically states that your money will last at least 30 years if you have 25 times expenses or greater. This theory has been statistically studied throughout all the 30 year periods of the US economy and consistently held to be true. It is an aggressive measure of financial independence, as we’ll see later, but it is a good starting point.
So do we Meet the 4% Rule?
So, where are we in respect to this guideline? Well as we’ve discussed before, I will not share exact numbers on this blog. I will however share some percentages and even year equivalents. So here goes. Based on non housing assets we have 22x annual expenses. So by the strict 25x current expenses definition that is a no. However, that is not the end of the story as the question quickly becomes how do you define assets and net worth?
I discussed previously that I do not typically consider my home equity as an asset. However, our mortgage is one of our expenses and just so happens to be similar to local rents. So we could in theory sell our home to release multiple years of expenses. Our yearly expenses would not change as rent would replace mortgage. What would be the impact? We hold another 7x annual expenses in home equity based on a recent appraisal. That brings us to 29 times annual expenses.
So with the selloff of the house we could cross the 4% barrier. However, this is the point where financial independence for the sake of retirement and financial independence for the sake of risk taking part ways. I have no desire to sell my home, and the steps in the next paragraph are even less desirable for me personally. I will not be selling my home so I can retire sooner. However the existence of these options does increase my overall security and ability to take risk which I have spoken regarding previously. In extreme situations where anything is on the table we could absolutely make this happen. We are not done yet.
Expenses and Financial Independence
If you recall in the past I spoke about the impact of growing expenses on financial needs in retirement. I mentioned in that article that most studies seem to indicate retirees reduce their expenses not increase. The thing is, if I’m honest we could cut out another 20% of our costs. Such a change would bring us to 27-28 x expenses. Well in line with the 4% goal. There are even other bloggers that live on budgets lower then the amount post 20% cut. So I know both by running my numbers and by bench marking that such a life would be doable. The thing is, for us personally that 20% cut would be one of deprivation. We would have to sacrifice several things we truly enjoy to make that 20% happen. It would not be worth it in that regard. What is 60 years of not working if you’re miserable because you can not buy the things you value?
Risk Taking Financial Independence
At this point we have hit what I consider as kind of a base type of financial independence for Risk Taking. The thing is, even if I was willing to trade miserableness for retirement I’m not sure the 4% rule is sufficient. I.e. even if I prioritized retirement over all else I do not think we are in a position to retire. You see, for longer periods beyond 30 years the 4% has a reduced probability of success. Early Retirement Now has a great series on this where he recommends 3.25% for longer periods. Simply put the 4% rule guarantees after 30 years you will have some money left. However, it does not guarantee you will have all funds left.
If you expect up to 60 years more on this planet, as I potentially have to plan for, then in 30 years from now you again need to meet the 4% rule for another 30 years. That means capital preservation over the first 30 years, which is a much more difficult proposition. I’m largely in agreement with ERN, so in general 3.25% is my bounds for financial independence. That is we will be ok if our net worth multiplied by 3.25% exceeds our annual costs. Even with extreme measures we are not financially independent in regards to this metric since 3.6% (our current risk based number) is greater then 3.25%. So mathematically we are not candidates for early retirement today.
Conclusions to Are we Financially Independent? Risk Taking or Retirement?
I’ll end this with one final comment. Even if that math showed we were ready for early retirement we would not pull the plug. I enjoy my job as it stands today and while we have big plans for retirement they are not executable today even if we had the means. It’s good though to have options and to know that the funds are behind me to weather most any statistically predictable storm.
You never know what the future may hold. An outlier could occur. Even the best plans, even the 4% rule itself, could be voided by something unforeseen. The key is to have a flexible plan and buy yourself many options. That is why I believe we are financially independent from a risk perspective. Because we can now weather the majority of situations and have prepared with the flexibility to adjust to most others.
Are you financially independent? From a retirement perspective? From a risk taking perspective?