The causal saver might be saving for the next purchase; a car, a sunny holiday destination, a house, the latest electronic device. But item after item where does that end? Let me provide you with a new goal, saving for your Independence!
The single most powerful measure of how you are doing financially and best indicator of how far off you are to financial independence: Your Savings Rate.
Savings Rate: (Annual Savings*/Annual Income) x 100%
*Where Annual Savings= [Annual Income-Annual Spending]
Simply, if say you are spending more than what you are earning, i.e. more than 100% of your income, you will never be able to retire and will technically be in debt.
On the other hand if you are spending only a tiny proportion of what you are earning, for example, 40% as an example, you are still financial dependent on your income but have shown that you can survive on much less than what you earn and you are a net saver (SR = 60%).
Now the magic starts here. If…If somehow your annual spending is zero, you are technically no longer dependent on your income to live and you can retire right away, continue living your free life. If you are one of the lucky few like me, this happened when you were a kid.
The reality is all of us are somewhere on the spectrum of savings rate. We earn and spend a proportion of our income (hopefully less than our income) and save the rest. Now the interesting thing is, the amount that we stash away each year can earn some money on itself (savings interests,CD interest, Bond yields, rental yields, stock dividends, investment yields, etc). As we save more each year, this income from savings can snowball year on year into something significant and if it approaches the level of our annual spending, we can be less reliant on working to earn an income to live. If it breaches the threshold of our annual spending, we are officially financially independent and can rely on this passive income to live.
- 4% Withdrawal Rule – you will be withdrawing within 4% of your entire stash to meet you annual spending during the decumulation phase (retirement)
- Your savings are invested to generate a growth of 5% annual return.
- Your stash is meant to last forever.
Someone really clever (?MMM) came up with the graph above which shows if you are able to achieve an annual Savings Rate of 64% with the above assumptions, you will be able to retire in 10.9 years time. The following table shows the number of years it take to achieve FI with the corresponding savings rate.
|Savings Rate||Years To FI|
- What I like about the savings rate is it is universal to everyone from the ‘rich’ to the ‘poor’. It applies equally to the high flier who brings in an annual income of £1,000,000 vs the poor city worker who only earns £20,000. Even if you earn an infinite amount of zeros, if your SR is 10%, the reality is you still have to work up to 51 years to become independent. Conversely, if you can achieve a high Savings Rate (70%) on any salary, you will be achieve FI in 8.5 years!
- Another note about the savings rate is that it includes the element of relative frugality to the equation. It implies that if you can survive on a lot less that what you earn, you will get to financial independence a lot quicker. Most people put a lot of focus on increasing your pay/income, but it works a lot faster if we can reduce our spendings relative to our income.
- There has been a lot talk about about savings rate on the personal finance blogs around. The best post about this are Mr Money Moustache’s The Shocking Maths behind Early Retirement and Monevator’s How to work out your financial independence plan. Both posts are a good read and backs up the assumptions with historical data, analysis and many more references.
- It is still worth taking a step back and realise this is just a model with arbitrary numbers. It might not be the perfect model (is anything perfect?) but it gives us the encouragement that mathematically the concept is sound and achievable. We just have to take action and use this as basis of our grounding principles to FI.
So how far are you till Financial Independence?