The Financial Independence Number is your savings goal to ensure you reach financial independence and can make work optional.This provides a specific goal for you to drive toward. It’s also important to keep in mind that what gets measured gets done and a goal not written down is just a dream.
There are several ways to determine your Financial Independence Number. The two most popular methods are using the income-based approach and the expense-based approach. Let’s discuss both methods including my opinion on which one is preferred for accelerating your journey to financial independence and making work optional.
Income-Based Approach
When you walk away from your job and decide to make work optional, your spending will likely change. A common rule of thumb by financial advisors is you should estimate 70%-80% of your current monthly income as your retirement spending.
If you currently earn $100,000, then this rule of thumb means you need to save enough to live off $70,000 to $80,000 per year. Using the 4% Rule, you will need to save between $1,750,000 and $2,000,000. Is this going to be enough for you should you walk away from your job? Maybe or maybe not. It is difficult to know what you need to save if you don’t have a solid spending plan in place for your work optional life.
This income-based spending approach is the most inaccurate as it does not consider your current spending, let alone what your potential future spending could be. With this approach, you are pretty much just pulling a number out of thin air and shooting towards is. You could be saving enough for work optional and retirement, but more than likely you are either saving too much or too little.
If you save too much, then you are delaying work optional and/or retirement life. If you save too little, then your savings will not last to maintain your desired work optional or retirement life. You will then need to either cut your spending, leading to a lower quality of life, or go back to work to maintain your lifestyle. This is not what you should be worried about when you make work optional or retire. Your life is meant to be enjoyed and live purposefully.
Expense-Based Approach
We have always advocated an expense-based approach to financial independence and retirement. By focusing on your expenses to calculate financial independence, this will allow you to accurately know how much you will spend and not over or under save.
For example, if you calculate your financial independence expenses will be $50,000, then you will need to save $1,250,000 when using the 4% Rule. When compared to the earlier income-based approach of 70%-80% of your income, you are saving $500,000 to $750,000 less for financial independence.
If you save $50,000 per year at an average compounded return of 7%, then it will take you an additional 4-5 years to save that amount, delaying your work optional life by that same amount of time.
Financial Independence vs Inflation
Once you figure out your expenses for financial independence, then you are all set to start saving and working toward the goal, right? Not so fast, my friend.
One area that is not discussed enough when working toward financial independence is inflation.If you don’t take this into consideration, then you will fall short no matter if you determine your initial expenses correctly.
Inflation can have a huge effect on your financial independence if you are not taking it into account. The longer your path to financial independence, the more that impact will be.
For example, let’s use the $50,000 per year you determined earlier will be what you need for financial independence. If you use the 4% Rule to calculate your Financial Independence Number, you will need to save $1,250,000 ($50,000 / 4%).
With your Financial Independence Number of $1,250,000, if you take thehistorical average inflation rateof 3% and expect to reach financial independence in 10 years, you will actually need $1,679,895. This is a 34% increase from your goal. This number is what I call theInflation-Adjusted Financial Independence Number.
This is only for 3% inflation. What happens if we maintain inflation that we’ve seen in 2022 where it’s been easily over 8%? You can expect the Inflation-Adjusted Financial Independence Number to be much higher.
Conclusion + FREE Financial Independence Plan Framework
If financial independence and making work optional is truly your goal, then determining your Financial Independence Number is essential.
One of the most common methods promoted by financial experts is to use the income-based approach of 70%-80% of your current income. However, this method is deeply flawed as it doesn’t really answer the question of what you really need for financial independence.
A better alternative approach is the expense-based approach that takes into consideration your spending and calculates your Financial Independence Number based on your spending goals. This allows you to ensure you are not saving too much or too little but are working toward the right amount for financial independence.
Once you know your Financial Independence Number, you are not quite finished and must take inflation and time to financial independence into consideration to determine your Inflation-Adjusted Financial Independence Number.
Discussing how to improve your personal finances is one of the things I discuss in myFREE Financial Independence Plan Frameworkguide that you can download below.
If you are serious about financial independence or are still thinking or learning about it, then you should get this free download. What do you have to lose? It’s FREE!
