The fiscal goal for everyone should be to become financially independent within their lifetimes, preferably as soon as possible. To be financially independent means that you have enough income generated by assets that you own to be able to sustain your lifestyle. For some people, this might mean a very modest lifestyle, while for others it could be a lavish lifestyle. What it takes in terms of portfolio value to be financially independent therefore varies from individual to individual.
Of course, while we have extra income coming in, we might have a higher standard of living than what we really need to survive and be happy. Maybe while working, you eat out most nights because you’re tired from a long day. In retirement, however, maybe you’d rather cook your own meals for the nutrition and because you enjoy cooking when you have the time. Determining what you need to be financially independent should therefore be based on your defensive, no-frills lifestyle instead of your normal, stable-job lifestyle. Basically, how much do you need to live on if you had to cut back to the minimum lifestyle you could sustain for a prolonged period of time? We’ll call this your “defensive financial position.”
So, obviously the first step to determining how much you’ll need to have saved away will be to determine the minimum income you’ll need if you’re in your defensive financial position. You might want more than this if you want to enjoy a few luxuries, but this number will tell you what the minimum you’ll need to have for security. What goes into your defensive financial position will vary, but things to consider are:
- Your monthly mortgage or rent
- Your monthly food expenses (assume cooking in most nights, with maybe a modest meal out per week).
- Clothing expenses (again, you’ll need to cut back, so just the minimums here
- Your monthly transportation expenses (car payment, maintenance costs, gasoline, insurance)
- Your monthly utilities costs
- Monthly life insurance and health insurance costs (assume you pay it all since you won’t be working), plus your yearly deductible and a reasonable amount for copays, divided by 12 to get the monthly number
- Home maintenance costs
Then, to your monthly defensive financial position cost, you’ll want to add the luxuries/extras that you’ll want. This is because you probably won’t want to live in your defensive financial position if you don’t need to since you’ll just be getting by in that state. For example, maybe you’ll want to spend $6,000 on vacations each year, or go to movies weekly. Figure out a monthly cost for these luxuries and add them to your monthly defensive position cost. This is the amount of monthly income you will need to generate to be fully financially independent at your desired lifestyle. This is how much you’ll need to live the life you want without an income from working.
Next, take that number and multiply by 300. That is the portfolio size you will need to generate that much income per month. This assumes a 4% withdrawal rate each year, which should be sustainable but will not leave any room for growth in your portfolio. If you want to be conservative and leave some room for your portfolio to grow and keep up with expenses over your lifetime, multiply by 360 instead. If you’re only looking at 10 years, the lower number might do. If you’re looking a 20 or 30 years, you’ll want to use the bigger number.
For example, let’s say that you have a defensive financial position of $4,000 and luxuries of $1,000 per month. Your needed monthly income would be $5,000, so you would need $5,000 x 300 = 1.5 M to be financially independent, or $5,000 x 360 = 1.8 M to be able to pay for things and still have your savings grow with time. Note that your minimum defensive position would be $1.2 M, which would be a portfolio big enough to sustain you at a minimal lifestyle for a long time. Getting to this point should be your first goal since then you won’t need to fear job losses.
You can reduce the amount of income you’ll need to generate by getting rid of some expenses. For example, if you pay off your home, you will no longer have a mortgage payment (although you’ll still need to make repairs and pay property taxes). You can also get rid of the car payment and instead buy quality used cars every five or six years. Another move to speed things along might be to downsize in home or move to a less expensive area and turn some home equity into investments.
And what if you’re sixty years-old and looking to retire at 62, but don’t have anywhere near the needed amount to be financially independent? Well, you could add Social Security payments to your monthly income from your portfolio (or reduce your monthly income needed by the amount of your expected Social Security payments). This would reduce the amount you’ll need to generate from your portfolio, making the amount you need in your portfolio smaller, but there is some risk here since the Government is $18T in debt and Social Security tax collections aren’t keeping up with payouts. This makes it likely that there will be a cut in Social Security payments in the near future. It therefore wouldn’t be a bad idea to not pin your hopes on Social Security payments, and instead think about working a bit later, maybe to 65 or even 70, to save up some additional money and reduce the number of years you’ll need to tap your portfolio. You can do this while you’re healthy and still plugged in with your company. It would be much more difficult to return when you’re in your seventies or eighties and having been out of work for fifteen or twenty years.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
