What is your financial independence number?

Most readers will be familiar with the 25 times expenses as a benchmark for financial independence. The rule is simple, once your net worth is equal to 25x (or a 4% annual withdrawal of your assets) you are now financially independent. As per most examples, $40k of spending on a $1m net worth. What number are you using for financial independence? Is this the same benchmark that you’ve been using or are targeting? Or do you a different metric?

Personally, I went for that level. I charted my expenses every month in a spreadsheet. Tracking my net worth and then steadily seeing the two lines converge until financial independence day.

However, I’ve come to realise the importance of a few additional metrics rather than just the standard 4% rule.

Critical to understanding what your financial independence number is the idea of asset allocation and income.

Asset allocation and income

Critical to my withdrawal rates is the allocation of assets. A lot of time is spent tweaking asset allocation. Whether to have more assets in public equities, real estate, or bonds. I had always been a 100% equities person. Now, post financial independence, and using a portion of my assets to sustain myself, my thinking has shifted.

Once I was making enough in dividends off my assets I started to modify asset allocation. There is great comfort in significant income from bonds, preference shares, fixed income, REITs and alternatives.

I’ve moved my thinking from a pure net worth maximisation perspective leading up to financial independence, to an income perspective.

It should be noted, selling shares and earning capital gains is the cheapest form of income. This is due to the highly attractive capital gains rates. However, I do not enjoy the net worth volatility that comes from drawing down on equities. A 30% move in income in a year feels incredibly volatile, and yet that is exactly what equities can do in a year. In fact it’s quite normal. Hence, I want to be able to draw on income that is more stable.

That leads to a preference for fixed income instruments. If I can combine a portion of my portfolio with these, it results in far better sleep. Everyone has their own levels of volatility.

I’ve switched to an income investment model, whereby I want to create diversification at the income level. At present I’m looking at a 20% of income per asset class. 20% from each of equities, bonds/prefs, real estate/REITs, alternate assets and unlisted businesses (online and physical). It still results in the highest net worth allocation to equities, but that’s just because of low yields.

Further to understanding your financial independence number is whether it is a gross or a net figure.

Adjusted safe withdrawal rate and impact on your financial independence number

The other aspects that have affected my thinking around a flat 4% safe withdrawal rate are taxes, sequence of returns, and inflation. These have all pushed me towards maintaining my level of spending, despite the net worth rising faster than inflation. The net effect is that my safe withdrawal rate is now starting to dip below 3%. I like this situation, since the more I can make a gap between the mathematical rules of 4% and my actual withdrawal rate, the greater my comfort with our financial situation and the path we’ve chosen.

I want the withdrawal rate at a level where it is actually irrelevant, say less than 1% of net worth. Instead I spend a portion of income – either by having net worth at 100x spending, or income that isn’t tied to net worth at all and just reduces my withdrawal requirements.

Now, in terms of the opening paragraph, there are three additional factors that make the 4% different in reality to determine your financial independence number:

• Taxes – you need to account for taxes on capital gains, on dividends, on rental income and interest income. Your country has a different optimal mix to mine, and as such it needs to be taken into account and the tax rules change every year, so these can cause fluctuations in optimal strategy. It results in slippage on either your income or your net worth, and the same as fees, results in a reduction in the net amount of income you can expect. The 4% is either a 4.5% gross if taken at a net level, or if you only want to take out 4% gross, it’s becomes 3%. Tax optimisation and structuring is important on the way to financial independence and especially after, and more fat in the numbers helps to offset a lot of slippage.
• Sequence of returns – ERN at Early Retirement Now has fantastic analysis on this subject. many are aware that the order of annual growth on your portfolio results in different outcomes for the same growth rates. Earning 30% and -30% is a better outcome than losing 30% then regaining 30%. The geometric mean is the same, but due to your withdrawal in the second scenario being on a smaller initial balance (down 30%), you then gain on a smaller portfolio. Hence the end point is different by around 3%. Compound that over a decade or three, and we’re talking real money. Initial losses are an issue if you’ve based your withdrawal rate at a higher balance on day of financial independence. The answer? Adjust safe withdrawal rate down in bad years, earn a side income, or just start with a lower safe withdrawal rate so you have greater margin of safety.
• Inflation – we’ve been blessed with a decade of incredibly low inflation. However, I’ve noted that certain categories are growing far faster, namely health care, and imported goods for us (electronics, motor vehicles, fuel). This results in a shift in the basket comprising our personal inflation rate. At some point my inflation rate is likely to exceed what it was in the past. This coupled with inflation due to age (more healthcare), as well as lifestyle inflation (I’d like to build a buffer, maybe we want more trips or a house in a more expensive country), so this too is making me discount the 4% rule. Your spending could quickly differ from such a fixed number, and your thinking changes significantly each decade you’re financially independent.

Our financial numbers evolve

Overall, it seems that despite hitting the 4% safe withdrawal rule, I’m still keen on growing our wealth and income further. I guess that the 4% is now such that I could quit my work, change paths, and know that I’d be fine. It also seems that due to the ambitions of many on financial independence, we seem to still like earning and challenge. Hence, we can/and often do continue to earn significantly. So what was a 4% rule that triggered financial independence/FIRE, is just the first step towards becoming less dependent on that initial cross-over point as the years pass.

The real gift being that we can now do it in alternate work/passion projects or be stay at home parents. It’s like building your own trust fund and assessing what you really want to do with your time.