This is a tricky question, that must be faced at the earliest possible. The key to financial freedom is to start early. The early you start, the early you reach.
As we know that financial freedom, here, refers to the ability to live or continue to live the same standard of life without bothering to work anymore. And in order to achieve that level of independence, we need to identify the number. The number is the amount that is needed in order to be financially free. This means that we must identify, in concrete numbers, the amount of money that is required today in order to sustain our life without bothering to work anymore.
This brings us to the central question of this discussion, i.e.
“How much money would you need in order to retire today and do not need to work again?”
That is the freedom to retire at our wish, and enjoy the life, rather than retiring because of not in ability to work any further. So, the idea here is to retire at a desired age.
For adherents to the financial freedom, and retire early, we need to calculate the number which is popularly known as “FIRE” i.e.
“Financially Independence, and Retire Early”
Conceptualising financial freedom, we must keep one point in our mind that financial freedom is not about calculating and achieving some number, but its a mindset that allows us to build wealth in such a manner that it can sustain our life and support our family financially without compromising on different ends.
We need to follow a flexible approach to approach FIRE number. For few, FIRE is linked with retiring early, which means getting free form employers, institutions, or any supportive family member.
With this point, we are now ready to move further and calculate the FIRE number.
FIRE number is the amount of money that we need to estimate and save and invest in different assets so as to provide for future.
Grant Sabatier is a renowned author of the best seller “Financial Freedom” and creator of financial site Millennial money suggest the use of FIRE number to achieve financial freedom.
It is suggested that achieving this number can make you go to the life you love.
Tracing FIRE number, we see that this number was the central agenda point of “FIRE movement” which is popularly known as “4% rule” and rooted in “Trinity” study.
Trinity study is one of the famous research studies done by Trinity University. The study focused on finding the withdrawal rates that an individual should use to sustain his/her life style for an average of 30 years. That means, the study wanted to find out a withdrawal rate which can support the expenses and can provide for the same expenses for a period of 30 years. The study also considered inflation into its results.
Now, on fetching the results of “Trinity study”, we get “4% rule”. Lets understand the 4% rule now.
The 4% rule state that if you keep the capital equal to FIRE number and withdraw 4% of that capital each year, and invest the rest at an average of 4% return then you can sustain your current standard of life for a pretty good period of thirty years.
That takes us to FIRE number, which is the core of 4% rule
So, in order to find the FIRE number, first of all you need to estimate your annual expenses.
Your annual expenses is the total amount that you need in order to support your lifestyle for one year. Multiplying your annual expenses with 25 will get you the FIRE number
Now let’s understand this with the help of an example.
Suppose your annual expenses are Rs. 10,00,000. Making 25 times of 10,00,000 will get you Rs. 250,00,000. This is your FIRE number
How are we going to use FIRE number ?
The answer to this question is that if you want to retire today and enjoy the next 30 years at the same standard of living, then you must have a portfolio or amount of Rs 250,00,000 with you. You must invest this amount in assets that can give you at least 4% rate of return.
How the 4% rule calculation work out?
Let’s understand the working of 4% rule now.
Suppose you place Rs. 2,50,00,000 in your portfolio and retire. According to 4% rule, you would withdraw 4% i.e. Rs. 10,00,000 in your first year of retirement. Now your rest of the portfolio must be invested in assets that generate atleast 4% interest rate. Considering this scenario your portfolio can support you for approximately 30 years.
What should I keep in mind while applying 4% rule or working out the FIRE movement?
While applying 4% rule we should keep few points of caution in order to make this rule or FIRE number work for us in the best possible way.
First, the withdrawal rate of 4% is a general number. It is a baseline scenario. Many studies have been conducted after the Trinity study and the withdrawal rates have been debated and adjusted according to different circumstances. But till date, the 4% is still a great number to start with.
The rule works if the portfolio gets in the position to work and generate atleast 4% return. Also, the portfolio assumes that you invest 50% in equity (stocks) and rest of the 50% in fixed income securities (i.e. debt, fixed deposits etc.). This is again a baseline assumption. Our actual portfolio may vary based on our personal preferences, risk taking capacity, time to retirement, and may vary overtime. Our portfolio is to a great extent reflection of our understanding of financial instrument, markets, experience, risk taking capacity, and understanding of return streams possibly can be generated.
The next assumption on which this “4% rule” works on is that it assumes a 30 year time period to sustain. It means that the portfolio is assuming the burden of 30 years to support. Elaborating on this, we mean that it assumes that you will require these funds for 30 years after retirement. In other words, if you retire at 60 years of age, then this fund assumes to support you till 90years. And if your plan is to retire early, then also the fund would work for 30 years. In case we wish to make this fund work for longer, we will have to rework our calculations.
One of the important points of caution is that the rule does not assume taxes, fees, or any sort of sudden emergency fund that you might require to pay for. There can be some sudden health expenses that might require larger amounts to be withdrawn out of the portfolio. So we must consider this point before relying on the rule.
Bottom Line
The whole idea of discussing these points was to improve our level of understanding on how the FIRE number and 4% rule work and make informed adjustments to the portfolio.