Keys to the FI Kingdom Part 3
Third Key to the FI Kingdom: Discover your target number by using Safe Withdrawal Rate.
Last time we discussed the first two keys to the FI kingdom: first, the belief that your narrative can change, and second developing a spending plan that works for you that includes amassing a 3-6 month emergency fund.
The Third Key to FI Kingdom: Discover your target number by using a 3-4% SWR (Safe Withdrawal Rate). What is a SWR and what do we mean when we say “Safe Withdrawal Rate”? It means you can “safely” withdrawal the desired percentage of your financial portfolio each year within a given timeframe (normally 30-50 years) without running out of money. You also have to decide whether your goal is to draw down on your capital (the money value of your investments) and hope it outlasts you OR to have a low enough withdrawal rate where you don’t drawdown your capital.
How much is enough? Well, first you have to know how much you spend, or rather how much you potentially need to spend in any given year. Once we know how much we need to spend in any given year we can find out how much money we need for retirement.
Enter the “4% Rule”–we’ll call it the “4% Rule of Thumb.” The 4% rule of thumb is a great starting place. To find your 4% rule of thumb number you merely multiply your annual expenses by 25 and that will give you a target amount. Or more preceisly, multiply the number you believe you’ll need to spend in any given year by 25–the difference is sublte but a big one. One year I might be healthy and the next year I might need to spend my total annual deductable. Your healthcare costs need to be “baked in” to your projected annual expenses.
By multiplying your projected annual expenses by 25 it will provide you with a portfolio amount that will (depending on your stock/bond mix) produce a 4% SWR that has a high probability of lasting for at least 30 years. Please note, a 4% SWR will most likely reduce your purchasing power over time. For this reason, I, along with Big ERN, advocate for a lower % SWR. However, let’s look at what a 4% rule-of-thumb SWR looks like. Jacob and Rachel spend 35k a year–which includes their healthcare monthly premiums and their annual deductible. So just take $35,000 x 25 = $875,000 = Target number which allows 4% SWR for a 30 year period (assuming a 50/50 stocks/bonds asset allocation–the higher the stock holdings the better long-term return is expected. See the Trinity Report, specifically the “Median End-of-Period Portfolio Values for Retirement Portfolios with Inflation-Adjusted Withdrawals” chart for 30 year time periods).
Fun fact: the lower you can reduce your “enough” number, the less you’ll actually need in investments, and the quicker you’ll achieve your goals!
If you haven’t read Mr. Money Mustache’s articles on this, well here you go—and you’re welcome:
Sidenote on the 4% Rule
This 4% rule-of-thumb comes from the Trinity Study. The study found that roughly a 4% annual withdrawal rate had a high success rate within a 30-year period—and by success they mean 4% withdrawals over a 30-year period would not exhaust the portfolio. So if you had $1.00 left over at the end of that 30-year period they called it a “success.”
However, Dr. Big ERN from EarlyRetirementNow.com has a great series on Sequence of Return risk where he points out that, for those of us who want a portfolio to last more than 30 years, the 4% rule-of-thumb success rate deteriorates to 65% at a 50/50 stock-bond mix within a 60 year period.
That means, if you want a greater probability for your portfolio to last longer than 30 years, you need to either 1. Reduce your expenses, or 2. pick up part-time work for possibly decades (see Dr. Big ERN on this one), or 3. Reduce your safe withdrawal rate by stashing more money away into your investment vehicles.
My vote is to option # 3. By placing just a little more money inside that perpetual money making machine, you’ll have the difference between having a high probability that your portfolio will fail to a high probability that your portfolio is going to grow in real purchasing power (purchasing power is the real value of your dollar, Euro, Yen, etc.)
For Dr. ERN, a more appropriate withdrawal rate for FI is 3.25%. Or you could increase your stock allocation to 75% and increase your withdrawal rate to 3.5% and have a 97% success rate (success= purchasing power and portfolio intact). All in all, you will need to decide what “Success” looks like given your time horizon and whether or not you want to spend down your portfolio or maintain its capital to then pass it on to charity or your heirs.
Here is the breakdown:
The Withdrawal Rates for Early Financial Independence (assuming at least a 50/50 Stock-bond split, but more ideally 80/20 stock-bond split):
4% W.R. ( 25 x Annual Expenses = 4% withdrawal rate) — First Level of FI
3.5% W.R. (28. 5 7 1 4 2 8 6 x Annual Expenses = 3.5% withdrawal rate) — Second Level FI
3.25% W.R. (30.7 6 9 2 3 1 x Annual Expenses = ~ 3.25% withdrawal rate) — Third Level of FI
3.0% W.R. (33. 3 3 3 3 3 3 3 x Annual Expenses = 3.0% withdrawal rate) — Fourth Level FI
2.5% W.R. (40 x Annual Expenses = 2.5% withdrawal rate) — Fifth Level FI
2.0% W.R. (50 x Annual Expenses = 2.0% withdrawal rate) — Sixth Level FI
Seventh Level FI — just stop… this is ridiculous, you have enough money already!
Start with the 4% rule-of-thumb. This allows you a really good starting point. If you expect to live off your investments longer than 30 years, or if you’d like to give your money away at the end of your life, then you should consider a 3.5 % SWR or below.
Fourth Key to the FI Kingdom: Purchase your freedom steadily.
Dollar Cost Averaging (DCA) is where you regularly purchase investments regardless of market highs or lows. When the market is up you’re buying fewer shares, and when the market is low you’re purchasing more shares at cheaper prices. Done regularly, your money is dollar cost averaged. Do this until you have enough money for the FI Kingdom. Caveat: if you obtain a large sum of money, it’s probably not a good idea to DCA the money into the market. Rather just put all the money into the market in one lump sum (See Jim L. Collins on this matter).
But, how much is “enough?” “Enough” is a word that is absent most of the time in my own cultural context. “The Good Ol’ USA” is a culture of “More,” “Never Enough,” and “Limitless goods and services.” This “Never enough” culture is most likely a contributing factor for unhappiness (see Shawn Achor’s talk on Happiness and the fact that happiness is always on the other side of the latest achievement—“You got into a big house, now you need a bigger house,” “You got into a good school, now you need to get into a better school,” etc.). What does it mean to have enough? Is that food, shelter, insurance, etc.—no frills. Or does enough include modest amounts of luxuries like weekly date nights and a beer making hobby? What about rising healthcare costs, children, and college? How will you know what is “enough” for you?
For me and my house, we have tested, and re-tested our spending plan through trial and error methodology. Since personal finance is as much a science as it is an art, taking an experimental mindset of curiosity is necessary for long term success. Failure can actually help with your creativity. We made mistakes, we over spent some months (and under spent in other months), but every new month is a new chance for success. It took about two years to find the sweet spot where we felt we were thriving instead of just surviving while maintaining a healthy investment percentage, and in that process we were developing frugality muscles–and so we changed over time as we became more efficient. The psychological reality is that if you play a zero-sum game of all-or-nothing, you will fail and give up within a few months–think in terms of a marathon. But, if you adopt an attitude of acceptance and commitment (Cf. Acceptance and Commitment Therapy and The Buy Nothing Year), you can learn to become mindful of your behavior, attitude, and learn to recommit to the values and behaviors you want in a realistic manner. It also just helps to follow a predetermined order of financial operation:
(1) Pay bills first and put back emergency monies into an online savings account
(2) Invest the money you’ve previously determined to invest in low-cost total market funds like VTI (Vanguard Total Stock Market Index Fund) and VXUS(Vanguard Total International Stock Market Index Fund). Side Bar: Investment order of operations: 401k/403b match, then IRAs, then HSA, 529 plans, and then after all tax-friendly investment options have been exhausted your Brokerage accounts.
(3) use an envelope system with the remaining money to address your spending plan needs.
(4) Evaluate/Re-evaluate your values, behaviors, and goals.
With this method we paid for our bills and our retirement first. So after several years, we found our “enough,” wich is what we live off now and is roughly what we expect to need in the FI Kingdom to come. We took our annual “enough” number and multiplied it by 25, which became our first tier target number. The next tier target number is ~28.57 x annual expenses = 3.5% SWR.
Side Bar: as you age expect to change, and with that expect that your spending to change. For example, medical costs will increase so we plan on having our mortgage payment paid off and the money that was allocated to the mortgage will then be allocated to anticipated increased medical expenses. I do not assume Medicare or Social Security in any of my calculations.
Summary of the four keys to the FI Kingdom.
- 1st Key to the FI Kingdom: Believe that you can change your narrative and decide what you want to achieve
- 2nd Key to the FI Kingdom: Develop a spending plan that works for you
- 3rd Key to the FI Kingdom: Discover your target number by using a 3-4% SWR (Safe Withdrawal Rate).
- 4th Key to the FI Kingdom: Purchase your freedom steadily.