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Friday, 31 July 2020

What really makes FI/RE work?

FIRE (Financial Independence - Retire Early) is a 'popular movement' of people (often Millennials) who are sick of the 'rat race' and consumerism, and wish to achieve financial independence (not relying on a pay check, but instead having a sufficient income stream from investments to either work as they choose, or even do a traditional 'retirement' (stop working) at a much younger age than usual (eg. age 65)). The key to FIRE is often seen as cutting out spending on mere 'wants' and instead using the resultant surplus income to invest.

To give an example of how effective cutting expenses and increasing savings rate can be at reducing how long one has to work until able to achieve financial independence and 'retirement', I did a simple excel model of how long it would take for invested savings to build up to a level sufficient to provide enough passive income to replace the income previously spent while working.

To keep it simple I made the following assumptions:

After tax income (available to spend/save): $100,000 pa for all years

Investment ROI is constant and is 7% pa after tax

Inflation is 2% pa, so the real ROI is 5% pa

In reality, returns will vary from year to year, and even if the average return works out to be 7%, actual results will depend on the size of variations and order (ie. return volatility and sequencing). And while DS1 is starting out in his first job straight out of uni at age 20 with a salary of around $100K (similar to my current salary, and also to the inflation adjusted amount I got in my first job after graduation), many people start out at a relatively low salary level and see their wage increase until their 50s. The actual after tax income level however doesn't affect how the model performs, as the required retirement income is calculated as a percentage of wage - so as long as your earn sufficient to be able to save part of your wage, the income level won't change how long it will take to achieve FIRE.

So, what does the model predict?

If you start at age 21 with zero savings/debt and save 10% of your after tax income, you would achieve the $1.88m investment balance to enable you to retire with a passive income of 90% of your after tax working income at age 68. This would mean you would have the exact same amount of disposable income in retirement as you had (after deducting the 10% being saved) while working.

If you instead saved 20% of your after tax income, you would only require $1.7m to retire, and would achieve that by age 54. The reason you require a lower final investment balance is because you have been living on 80% of after tax income, rather than 90%. This is one of the 'secrets' of FIRE - by adjusting to living on a smaller percentage of your income while working, you can reach that level of investment income much sooner. (If you had instead saved 20% of income, but wanted to still retire on 90% of income, the investment balance required to fund retirement would have remained at $1.88m, but you would have achieved it by age 58 by saving 20%, rather than age 68 by saving 10%.

If you cut spending to boost the saving rate to 30%, the investment balance required to fund retirement reduces to $1.53m, and you'd get there by age 46.

And by saving 40% of after tax income you could retire by age 40 with an investment balance of $1.3m.

By saving 50% you could retire by age 36 (with $1.18m), and by saving 60% you could retire by age 32 (with under $1m).

By now it should be obvious that using FIRE to achieve early retirement is partly a trade-off between retirement age and the level of spending possible both while working and during retirement. Some people who have tried FIRE have found it too hard to cut current expenditure significantly. While how much one can take from current spending and divert towards saving for 'financial independence' will depend on personality (FIRE isn't for everyone), I suspect that some people who find it hard to reduce spending while they are working are in for a very unsatisfactory retirement when they suddenly find their income slashed involuntarily.

The sequencing risk is also not to be underestimated - I always saved around 30% of my after tax income, and was on track to be able to afford 'early retirement' by age 50, but that was before the GFC. So its probably worth building in a couple of extra years as a buffer when planning for FIRE.

Another aspect that I've come to realize is that once you have achieved your 'FI' target you may not want to 'RE'. I actually passed the minimum amount of superannuation savings required to replace my rate of expenditure (current wage income - taxes and savings), and am now working towards hitting the $1.6m transfer balance cap), and hope to transition from working for a salary to working for myself in  my own financial planning business. Achieving financial independence means that you are actually choosing to work (even if it is still in the same old job), rather than having to work.

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1 comment:

Financial Independence said...

Hello there,
Thank you for your post.

I agree with your observation, there is also caveat that retiring young, is like having a new car. With the age expenses on medical, house maintenance will only grow.
Retiring at 30 yrs is also assumes no kids /no expenses grow.

So the biggest secret to FI is having high initial salary. Saving $100 a month is helpful but its not going to cut it in the long run.

I also think that most of the FIRE blogs are fake. People either working or one of the partners are or just making the stuff up :-)
What may really accelerate the FIRE is two working in profitable jobs. I had an acquaintance - both of them worked in $12 K after taxes each for 10 years abroad. So they saved
about $200K a year for 10 years. She is now sitting at home mom, while he is still getting his $12 K a month.