The Financial Independence formula is a calculation do determine whether you have enough Net Assets to live on for the rest of your life.
The Financial Independence formula should not be confused with the Financial Dependence formula which is a calculation on how you will have to work for the rest of your life.
What is the basic Financial Independence formula?
The basic financial independence formula is:
Asset Returns > Expenses
This is the 101 way of understanding financial independence. On the day that your assets can pay for the expenses for the rest of your life, you are financially independent.
Hopefully, you remember the great truth but there are only two certainties in life death and bills. To be financially independent, you need sufficient assets to pay those bills forever.
When your acid returns are greater than your expenses, you are financially free. You need never work another day in your life.
So now we understand the basic principle of financial independence, let’s try and calculate how much money you need to be financially free.
How to calculate your financial independence
First, we need to calculate the Expense side of the the equation.
You should already know your monthly expenses. If not, go calculate them now. Multiply your monthly expenses by twelve months and you will have an estimate of your annual expenses.
Next, we need to understand the asset return side of the equation to see if one is greater than the other.
You should also already know your Net Asset position. If not, quickly calculate it.
For simplicity at this stage, we are going to assume that the real rate of return on your net assets is 4% each year. Don’t worry about how accurate that is for now. It’s just a simplifying assumption.
If I multiply my Net Asset position by 4%, I will get an estimate of my annual asset returns.
For example, if Harry’s Net Asset position was $500,000, his annual asset returns would be $500,000 x 4% = $20,000.
All Harry needs to do now is to compare his $20,000 annual return with his expenses. If his expenses are less than $20,000 each year, he could pay all his expenses with his net asset returns. So if Harry only spends $20,000 a year or less, he could now announce he’s financially free.
That is the basic 101 model for financial independence. But, we are going to get a little more sophisticated and move from the most simplistic model.
You’re probably asking number of questions right now. For example, how do I know if my returns of 4% or what if the return varies over time?
Fear not, all will be answered.
The beginners way to calculate financial independence
Above, we saw the basic formula for financial independence it’s to make enough money from your assets pay all your bills.
A simple rearrangement of the formula can help us a lot now. As we’ve seen that financial independence is when:
Net assets multiplied by annual asset return is equal to my annual expenses.
It must also be true that you are financially independent if:
Annual expenses multiplied by the inverse of annual asset return is equal to net assets.
So, in the case of Harry, if his annual expenses are $20,000 and his annual asset return is 4%, then the net assets he needs are $20,000 multiplied by the inverse of 4% – which is 1 divided by 4% – which equals 25. So $20,000 multiplied by 25 = $500,000.
Harry needs net assets of $500,000 to be financially independent, if he has expenses of $30,000 a year and a real asset return of 4%.
Refining the Financial Independence formula
There are few complications which we should address.
The rate of return on assets varies over time.
Therefore, rather than the real asset return, we want the safe asset rate of return, also known as the safe withdrawal rate.
The safe withdrawal rate is a level of asset return that we can be very confident will mean never losing our money if we spend that much each year.
Your safe withdrawal rate is determined by the total return you expect from your investments, adjusted for expectations on future inflation.
This in turn is based on the mixture of assets you hold, and the best expectation of their total return over time.
Asset allocation mix matters
When you keep money, you have many choices of where to keep it. Most common for regular working people is they have money paid into a bank account ever few weeks from their employer. From that moment on, it is an asset unless they spend it.
So many people have made an asset allocation choice without doing anything at all. Any unspent money is sat in a bank current or checking account. Similarly, if you were to keep all of your spare coins in a piggybank, this would be asset allocation.
So, is this a standard bank or current account a good place to keep your hard earned money if you want to achieve financial independence? Short answer is no. But let me explain why. To achieve financial independence do you want to have the best in the long run total return on your investment. Total return means the best combination of capital growth, dividends, interest, royalties for your money to grow over time. When you leave your money in a standard bank account, that money receives no capital growth, no dividends, and no royalties. It may be receiving interest. Interest is the bank paying you a fee in exchange for you lending them your money. In times where interest rates are low relative to inflation, the total return on your cash in a standard bank account is likely to be low or even negative.
Here’s a quick example. Inflation rate is 2%, your bank interest rate is 1%. You add $100 to the account and leave it for a year. After one year, you have earned 1% in interest so your bank account says you now have $101. But, thanks to inflation, the price of everything else has risen so you actually only have $99 of value compared to the previous year. It’s obvious that if your money is falling in value year after year, the safe withdrawal rate will be close to zero because that money has to last for the rest of your life. Even if the interest rate was positive versus inflation, many banks are now charging a fee for their services. All transaction fees erode your returns. Lastly, you will find that any money you do make in a standard bank account from interest may be taxed, leaving you with even less money.
We’ve established that a standard bank account, or a piggybank, are not going to allow you to achieve financial independence unless you have an enormous amount of assets. It is clear that you must find a place to keep your money that generates significant real returns above inflation.
If you have read the last couple of paragraphs with a twinge of fear, don’t worry. This is normal. You worked extremely hard to earn the money you have. You have been told that the banks are a safe place to put your money. And yes, most countries have protection schemes in place to ensure that your money should the bank collapse. But they do not protect you for inflation or for derisory interest rates. For almost everybody, to become financially independent, you must invest your money somewhere with higher return.
You can judge any investment factually by looking at its liquidity, its historical capital returns, its historical yield, any tax benefits or exposure, and level of diversification. However, as you so often read past performance is not a guarantee of future returns.
Financial Independence Formula – Rule of Thumb
The Financial Independence Rule of Thumb can be used to quickly estimate the amount of net assets needed to be financially independent.
Because it is a simplification, the Financial Independence Formula – Rule of Thumb is based on two assumptions.
- Current annual expenses equal future financial expenses.
- The safe withdrawal rate on your net assets equals 4%.
With just those two assumptions, you can immediately calculate the amount of net assets you will need to be financially free.
Example calculation of the Financial Independence Formula Rule of Thumb
Remember Harry. He has annual expenses of $20,000. Running his number through the equation.
$20,000 x 25 = $500,000 = Financial Independence for Harry
So on the day Harry has saved and invested enough to reach $500,000, he can declare himself financially independent.
Health warning about the Financial Independence formula
The FI formula comes with a big health warning stamped on it!
The calculation is so easy to make, and the assumptions undermining appear so simple. Be cautious. Reaching the FI Rule of Thumb position does not necessarily mean you can chuck in your job and go sailing around the Bahamas for the rest of your life.
Why not? Because of those two little assumptions that the rule of thumb is built on.
You will also note that the FI Formula Rule of Thumb gives no clue about how long it will take to reach financial independence. For that, you need to understand your savings rate.
What’s missing from the Financial Independence Formula?
If you’ve been paying attention, he may have noticed a big important number is missing from the financial independence formula.
Income!
The formula factor is in expenses, and it factors in return on your assets, but it says nothing about the income you earn from your job.
This seems strange.
Income is not relevant for calculating how much you need to be financially independent. But it is extremely relevant for calculating how long it will take you to achieve financial independence.
The three levers of Financial Independence
Once you understand the basics of the financial independence formula, you can see that really there are only three levers to worry about.
If you want to reach financial independence, you will need to find a balance between the following three activities:
- Reduce your expenses
- Increase your income
- Improve your return on assets
When you reduce your expenses, you drive down the future required net assets needed to fund those expenses.
When you increase your income, you increase the amount of money available to invest.
When you improve the return on your assets, you increase your safe withdrawal level, and you accelerate your path towards financial independence because the money you have invested will be earning a return on top of your income.
Key Takeaways
- The 101 calculation of Financial Independence is when your asset return is equal or greater than your expenses.
- The Financial Independence Formula Rule of Thumb is 25 x annual expenses equals Financial Independence.
- There are three ways parts to reaching financial independence: Reduce expenditure, Increase income, Improve return on net assets.
Key Actions
- Calculate your own FI Formula Rule of Thumb
What’s next?
You are now ready to understand your savings rate.