What would you do if work was optional? This state of freedom is known as financial independence (or retirement).
Your financial independence number is a portfolio size, held in stocks and bonds, that can be expected to provide investment income to cover your expenses until you die.
This post covers a three-step process to find your financial independence number. Finally, I cover a process to set monthly investment targets to meet your financial independence goal.
Table of Contents
Step 1: Estimate Annual Investment Income Needed in Financial Independence
First, you will need to estimate your expenses in the financial independence stage. You will need enough investment income to cover these expenses.
Your expenses in financial independence depend on your future goals, and people have a hard time knowing what they want in the future. Therefore, consider using solid goal-setting practices.
Also, consider that frugal living habits needed to build wealth are unlikely to disappear in retirement. It’s hard to change habits, especially when you’re older.
For this post, I assume your expenses in retirement are $65,000/year in today’s dollars.
Using today’s dollars keeps everything simple. Don’t worry about inflation… it’s captured in the steps below.
Step 2: Find Your Safe Withdrawal Rate
Your safe withdrawal rate (SWR) measures how much investment income you can draw from your portfolio (of stocks/bonds) each year until you die. The investment income would increase with inflation so that you retain purchasing power.
For example, consider a 3% safe withdrawal rate and a $1,000,000 portfolio. A 3% SWR means that the portfolio is expected to provide $30,000/year of income, adjusted for inflation, for life.
Picking the right SWR is the most crucial step in this post. Your target SWR will likely be between 2% and 3%.
An SWR in this range reduces the probability of running out of money in retirement to <10%. These SWRs are for a low cost globally diversified index portfolio of 60% stocks and 40% bonds.
Check out this article on safe withdrawal rates to learn more about SWRs and pick the right SWR for you. The post includes a review of two key academic studies on SWRs.
Some unique factors when picking your SWR include:
- Retirement age and how long you need to live off investment income
- Your willingness to adjust spending during financial independence in response to market conditions
- Your capacity to earn income in retirement if required
I assume a 3% Safe Withdrawal Rate (SWR) for the next steps. This happens to be my target SWR based on my unique circumstances.
Step 3: Find Your Financial Independence Number (Target Portfolio Size)
Now you can find your financial independence number. Just divide your annual investment income needed for financial independence by your safe withdrawal rate. The output is your target portfolio size in today’s dollars.
I set a target investment income of $65,000/year in step one. In step two, I set a 3% SWR. Therefore, the financial independence number (target portfolio size) is: $65,000/3% = $2.17 million.
Now you have your financial independence number. You need this portfolio size to reach financial independence (and retire).
But how much do you need to invest monthly to build a portfolio of this size? Let’s figure that out.
Step 4: Find Monthly Investments Needed To Reach Financial Independence
It’s time to set a monthly investing target to grow a portfolio that is equal to your financial independence number.
There are three main variables that help you determine how much you need to invest monthly:
- Time invested (in your control)
- Investment rate of return (not in your control)
- Amount invested monthly.
This step will show you if your financial independence goal is realistic. If it’s not realistic, you may need to delay financial independence. Alternatively, you can set goals to earn more income or cut expenses to invest more aggressively.
Globally diversified index funds optimize risk-adjusted returns. Therefore, let’s look at reasonable return expectations for index portfolios.
Expected Investment Returns
I use the inflation-adjusted returns for a global index over the past 122 years (source):
- Stocks: 5.3% for a globally diverse stock index fund
- Bonds: 2% for a globally diverse bond index fund
Do these returns seem low to you? That’s because you usually deal with “nominal” returns, where inflation is not subtracted.
In nominal terms, global stocks have returned 8.3%, and bonds 5%. Inflation has run at 3% historically. I don’t use historical US stock returns (10%) because the US suffers from survivorship bias.
Monthly Investments Required
Now for the exciting part. You can determine how much to invest monthly using a compound growth calculator. The three variables to enter into the calculator:
- Financial Independence Number (you have this)
- Returns (based on your stock/bond mix)
- Time Invested
There are two ways you can use the calculator:
- (1) Use trial and error to input monthly investment amounts until you find your target portfolio size.
- (2) Use a target date function in the calculator linked above. Input your target portfolio size, the annual return, and the date. The calculator will tell you how much you must invest each month.
To produce the target portfolio size of $2,17,000, you will need to invest:
- $1,308/month for 40 years
- $2,480/month for 30 years
- $5,065/month for 20 years
Financial Independence Number: Other Considerations
Welcome to the random thought area. These are thoughts that don’t fit well into the structure above.
- I do not recommend you invest in stocks and bonds on your own until you understand investment risk and are ready to invest. Stock market returns are not guaranteed, even over a 30-year horizon.
- A government pension in retirement reduces your required investment portfolio size.
- I did not account for taxes on investment income. The good news is that investment income is taxed at a lower rates than your employment income.
- Tax-sheltered accounts like the TFSA and RRSP help you reduce taxes on investment income.
- Income provided by other investments, such as real estate, are not captured above.
- It is essential to understand the risk associated with your safe withdrawal rate. Nothing is perfectly “safe.”
- Time is a massive factor. Due to compound growth, investing early makes a big difference.
- Work is often a key source of well-being. Retiring early to do nothing will get boring very fast. For more, read the problem with Financial Independence Retire Early.
Conclusion
There are four main steps to size and grow your investment portfolio for financial independence:
- Set financial independence goals and identify the investment income you need in retirement.
- Pick your safe withdrawal rate.
- Find your financial independence number.
- Determine how much you need to invest monthly to meet your financial independence number.
Jake out.