What’s your number?
This post is part of the Financial Freedom Guide series
You have an idea why exponential growth matters a lot to your Financial Freedom journey. So how much do you need to save and invest to achieve Financial Freedom anyway?
“Money, if it does not bring you happiness, will at least help you be miserable in comfort.”
The math for Financial Freedom is simple
The formula for Financial Freedom is:
Let's break this down.
Safe withdrawal rate
The safe withdrawal rate is the percentage of your initial capital that you reasonably believe you can withdraw each year without risking running out of money. This can be at a rate that either:
Consumes your capital over a certain timeframe (e.g., 30 years). For example, many traditional retirement plans assume you will retire around age 65 and then slowly withdraw most if not all of your savings over the next ~30 years.
Grows your capital by withdrawing less than your portfolio generates in investment returns every year (e.g., dividends, capital gains). This creates permanent capital - also known as “dynastic wealth” - that you (and your children) can hopefully live on forever.
If you are going for Financial Freedom with a long life ahead of you and/or want to pass your wealth on to your children, pick a safe withdrawal rate suitable for the second option.
We've already discussed that the stock market has historically returned 10% in nominal and 7-8% in real (after-inflation) terms. So that means if you are fully invested in the stock market, you should be able to withdraw on average 7-8% and still maintain you capital, right? Yes, BUT this would have substantial "sequence of returns risk".
Let's illustrate this with an example: Say you had $1M invested and you decided to withdraw 10% of your original investment every year (i.e., $100k). Ignore inflation for a second. Now imagine two scenarios:
Scenario 1: The stock market grows 100% in year 1, then doesn't grow at all (0%) in years 2-10
In year 1, your invested $1M grows to $2M. You then withdraw $100k in each of the 10 years and end up where you started at $1M. So far so good. But look at scenario 2…Scenario 2: The stock market doesn't grow at all (0%) in years 1-9, then grows 100% in year 10
In each of the years 1-9, you withdraw $100k, meaning you enter year 10 with with just $0.1M left. That amount then grows 100% to $0.2M in year 10 and you withdraw one more $100k, leaving you decidedly financially "un-free" at $0.1M.
Net worth ($M)
Notice how even though the market had the same 10 year return, you experienced very different outcomes. That is sequence of returns risk.
There are several ways to better understand this risk - from backtesting to Monte Carlo simulations. The simplest way to mitigate sequence of returns risk is to withdraw less (at least in early years) than the theoretical maximum implied by historical average portfolio returns. A lot of smart people have spilled much ink debating what the safe withdrawal rate should be for a variety of portfolio makeups and market conditions. The right answer appears to lie somewhere between 3-5%, with most experts agreeing that the so-called "4% Rule" is incredibly robust even if your investment horizon exceeds 30 years.
Side note: If you are extremely risk averse, remember that stocks pay dividends of about 2-3% p.a. on global average. So you could always decide to only withdraw those dividends and never sell any shares. This approach would be maximally - and likely unnecessarily - conservative. Many university endowments - which try to withdraw as much as they can for university operations while maintaining their capital for the next generation - withdraw considerably more than 4%. Yale’s endowment, for example, withdraws as much as 6.5% annually.
Annual spending & capital required for Financial Freedom
So let's go with the 4% Rule. It's extremely well tested, conservative for Financial Freedom portfolios, and makes the math easy. If we insert 4% into our FF formula above, we find that we need to save and invest 1 / 4% = 25 times the planning future annual spending to achieve financial freedom.
So if you want to spend $50,000 every year, you need $50k * 25 = $1.25M to gain financial freedom. You want $100k in spending money every year? You'll need twice the capital - $2.5M saved up and invested. You can manage on $3k a month (i.e., $36k a year)? $900k will be enough for you. Go ahead and play with the numbers:
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Do you have any thoughts or questions? Leave them in the comments below!
Now that we understand the safe withdrawal rate and how it impacts our required capital for Financial Freedom, let’s talk about the all-important annual spending number!
