If you look up the financial independence retire early (FIRE) movement you will inevitably come across the 4% rule. It basically says that if your expected yearly retirement expenditure is 4% of the size of your investment portfolio that will be sufficient to last you forever through the vast majority of market ups and downs. So if your yearly retirement expenditure is $50,000 then you’ll need $50k/0.04 = $1.25m to retire, easy right? Actually it’s not often that simple, here’s why.
The feeling of freedom is a highly subjective to the individual. For some, that means quitting and never working again. For others it means working part time or being in the position to start a business without risk to their lifestyle if it fails. Or it could simply mean being debt free. For me, I’d like to be able to cover our basic household expenses and be in a position to work part time or work on finite life projects with lengthy periods of unemployment in between.
If you’ve just used the 4% rule to figure out how big your investment portfolio needs to be you may have just said something like “Damn! I’m never going to get there!”. Let me share with you some motivation from my personal experience. As of this post our portfolio size isn’t large enough to call ourselves financially independent, however, at its current size, it would take years to become depleted if we both chose to quit our jobs today. Combine that with the fact that we are mortgage free it gives us an immense sense of security, achievement and the drive to continue the journey towards financial independence. So if you ever feel like you’re stuck in the grind of working towards financial freedom, remember that with each day that choose to follow your plan is a day that you are moving in the right direction and the feeling of freedom is not only felt at the destination but increases with each day that you get closer to it.
With that being said, you can greatly reduce the requirements on your portfolio if you’re willing to do some work to supplement your expenses. Further to this I believe that financial freedom should be sort after with the intention of giving you the freedom to do that which gives you joy and adds value to your life. More often than not these activities will generate an income. The graph below shows the portfolio size that is required under the 4% rule for varying levels of active income at 3 different annual expense levels.
Required Equity vs Active Income
$30,000, $50,000 and $80,000 p.a. expenses
A few key take ways from the graph is that for every $10,000 p.a. of active income you are willing to work for, you need $250,000 less in your investment portfolio. On the flip-side, for every $10,000 increase in yearly spending you will require an additional $250,000 in your investment portfolio. So if you currently feel that the cost of financial freedom is too high you can simply opt to earn some income from a part time job or hobby as well as look for ways to decrease your spending requirements.
So to summarise:
- Use the 4% rule to get a good approximation for how large an investment portfolio you will require to fund your retirement
- Decreasing your cost of living significantly reduces the required size of your investment portfolio
- Every $10,000 reduction in cost of living results in a $250,000 reduction in required portfolio size
- Earning money through enjoyable, challenging part time work will have the same effect on portfolio requirements as reducing living expenses
- The sense of financial freedom builds throughout the journey
Engineer your freedom