The Magic Number Behind Financial Freedom

To me, financial freedom is the most glorious phrase - even better than free Manolos. What is financial freedom? It is the point at which our assets (investments and income from real estate, for example) produce enough regular income to cover our expenses. I find the idea magical! Financial freedom means we’ve invested so much that our own money has turned into our primary source of income. At this point, we no longer “need” to work for income.

At first, financial freedom sounds impossible. Only for the very wealthy, or for the tremendously lucky. I acknowledge that this magical concept isn’t accessible to everyone. However, the cold, hard math suggests that far more of us could achieve financial freedom if desired; it is a choice that requires us to prioritize growing our wealth.

You may aim to achieve financial freedom in order to retire in your 60s (or later). Or, you might be driven towards an earlier date; your 50s, 40s, or even 30s. I've shared that my goal is to reach financial freedom by 45 (or earlier). If the idea of a “work-optional” life appeals to you, there is one key number you need to understand. This number makes it possible to eliminate the need to work in a traditional career, or stop working all together! So what is it?

Four percent, which refers to the 4% safe withdrawal rate (also called the 4% rule). Why 4%? Several studies have confirmed that retirees can safely withdraw 4% of their nest egg every year, without the risk of running out of money, and without adding to their savings. While the returns on investments will vary (some years more than 4%, some years less than 4%), if you consistently withdraw 4% annually, you’ll avoid the risk of completely depleting your funds. Here’s a roundup of some of the most relevant research.

The most well-known exploration includes the Trinity Study, which originated at Trinity University. Professors explored market data between 1925 and 1995, seeking to understand what withdrawal approaches wouldn’t exhaust the retiree’s nest egg. They wrote, “Withdrawal rates of 3% and 4% are extremely unlikely to exhaust any portfolio of stocks and bonds during any of the payout periods [15- or 30-years].”

Even before that research, William Bengen’s 1994 study, Determining Withdrawal Rates Using Historical Data, analyzed and tested various withdrawal rates against historical market data. The maximum rate that retirees could withdraw without depleting their savings? You guessed it - 4%. One important assumption in this study is that 50% of the portfolios were in bonds. (It is common for retirees to place large amounts in lower-risk investments like bonds. I personally plan to have a longer retirement and will put far less than 50% in bonds).

Finally, Michael Kitces, a financial expert and lifelong learner who has many professional designations in the world of finance (see them all here), also examined periods of time going back to the 1870s - and he found that there isn’t a 30-year period in which a 4% withdrawal rate was too high. His fascinating post is here.

You can find endless information on the 4% rule and it is important to explore the studies, in order to understand the relevant assumptions. Importantly, if you believe the studies (which I heartily do) you can do some serious planning for financial freedom.

Let’s play along: if your living expenses are $75,000, you’d need to have $1.87M in order to fully cover your expenses. (You would withdraw 4% of $1.87M, which is $75,000.)

But, let’s say you spend some of that $75,000 on your mortgage (which you will pay off before becoming financially free), saving for retirement, and investing in a college fund for your niece (who goes to college next year). Then, these are expenses you won’t have to account for in the future; you might really spend only $50,000 each year! This lowers your investment requirement to $1.25M.

If you’re like me, you probably have lots of questions.

What about inflation? Simple answer: keeping some of your money invested in the market will fight inflation.

What if you want to spend more when you're financially free? That’s great; just up your budget appropriately and re-calculate the nest egg required.

What if 4% feels too risky for you? Change your withdrawal rate. Use 3.5%, 3%, 2.5%...whatever you feel comfortable with.

How can you know what your future budget will be? Short answer: create your best model based on your current budget. Longer answer: check out my next post.

In summary, the 4% rule gives you a tangible, specific number to work towards in order to achieve financial freedom. You may think the amounts required to generate income to cover your expenses sound impossibly big. You might ask yourself, “How the heck will I ever save $1.25M?!” I’ll tell you - one dollar at a time. The magic of compound interest will help you grow your money at a fast rate over time.

There’s plenty of discussion on whether the 4% rule still holds true today, as time in retirement lengthens. I encourage you to explore alternative models and determine what would work for you.

One thing I can promise? You’ll never get there if you don’t get started. Your path to wealth all depends on what you do with the space between your income and your expenses. If you grow that space, by increasing your income and reducing your expenses, you give yourself a greater opportunity to achieve freedom earlier.

I'm also a big fan of starting small and persistently increasing your investments over time. Figure out the best estimate of your target nest egg and get investing. I’ll see you in financial freedom!

Do you believe the 4% SWR? If not, what withdrawal rate do you prefer? Let me know!

xoxo, Ms. Financier