How do you measure Independence?
Source: Rocket50
By: Staff Writer
Date: July 2, 2023
Do you define your personal independence financially? Or, by your activity level or abilities? Or by your living situation?
Maybe you think about all three. In the next few weeks, we'll look at independence through each lens, starting with financial independence.
What is financial independence for you?
Each of us has different living needs, desires, and expectations, so our expenses and financial needs in retirement will differ. But, in short, financial independence means you have enough money to cover all your expenses without working again. The key is to know what that number is for you so you can see whether you're on track to reach it before retirement. If your passive cash flow covers all reasonable expenses for the rest of your life, you're considered "Financially Independent" and you don't need additional income again. You may choose to return to work (or not stop working) after the typical retirement age for social/emotional reasons: staying engaged definitely enhances the quality of life. But for today, we'll look at a few different ways to measure your readiness to live without the need for a working income.
There are six important measures that can help you get on track to achieve financial independence before retiring. Each of them compares your annual expenses to your assets over time.
- Expected life - # of years you will live after retiring
- Safe Withdrawal Ratio
- Retirement Savings Ratio
- Millionaire Next Door Formula
- Sound Retirement Income Score
- Debt to Assets Ratio
You are financially independent when your guaranteed annual income sources (Social Security, Pension, Rental Income) plus 3.5% of your investment portfolio are greater than your annual expenses.
The 3.5% of assets is considered a conservative or “safe” withdrawal rate for someone who anticipates living off their assets for at least 30 years.
Let’s say a couple has expenses of $90,000 per year. When they turn 62, they expect to have the following guaranteed income sources in retirement:
- Spouse 1: Pension: $500 per month, $6,000 per year
- Spouse 1: Social Security: $2000 per month, $24,000 per year
- Spouse 2: Social Security: $1300 per month, $15,600 per year
- Wholly-owned rental properties: $2000 per month $24,000 per year
In total, they have $67,600 in Guaranteed Income. On top of this, the couple has $400,000 in retirement savings accounts. 3.5% of $400,000 is $14,000 per year.
Their Financial Independence Number is:
$67,600 in income + $14,000 in safe withdrawals = $81,600 in total income.
Their total expenses ($90,000) - expected retirement income ($81,6000) = -$8,400.
The couple has to cover an $8,400 per year gap before reaching financial independence. To hit their number before retirement, they can lower expenses or increase their savings. Playing with the numbers in a retirement budget calculator can help them decide which makes the most sense.
What is a "Safe Withdrawl Ratio"?
During retirement, a portion of a retiree’s spending will be covered by guaranteed income (i.e. Social Security, Pension Benefit, etc.) at rates ranging from 3-4% of their portfolio annually. This is considered a “safe” withdrawal rate. At this rate, retirees are unlikely to run out of money during a 30-year retirement assuming a 60/40 stock/bond asset allocation. While this is considered 'safe', this ratio is especially important during the early years of retirement, when retirees have longer to live and therefore need their portfolio to last longer. As a rule of thumb, you simply want to keep your withdrawal ratios below 4% when analyzing different scenarios.
Retirement Savings Ratio
The retirement savings ratio tells you how much more you need to save to reach financial independence before retirement.
The retirement savings number can be calculated as follows:
Annual essential expenses – annual guaranteed income = annual portfolio withdrawals.
Portfolio withdrawals are the amount you will withdraw from your portfolio each year. Multiplying the annual withdrawals by 25 to 33 gives you the nest egg you need to retire.
The couple in the example above has $67,600 in “Guaranteed Income” each year of retirement. But they spend $90,000 per year.
The couple needs to withdraw $22,400 per year ($90,000-$67,600). For a 4% annual withdrawal rate, they need a portfolio with $560,000 ($22,400 X 25). If they want a more conservative 3% withdrawal rate, they need $745,920 ($22,400 X 33.3).
Millionaire Next Door Formula
Unlike the first two measures, The Millionaire Next Door Formula shows your likelihood of becoming a “Millionaire Next Door” before you retire instead of measuring retirement readiness or financial independence.
This formula multiplies your current annual income by your age. Divide that by 10. The number remaining is a good target for your nest egg.
A couple with an average age of 58 has a household income of $150,000. 58 X $150,000= $8,700,000. Divided by 10 leaves them with a target net worth of $870,000.
Ideally, this couple will have a nest egg with at least $870,000 in it by age 58.
NOTE: If you do the math and find that you’re “behind" where you might want to be, don't panic! Many people face lower incomes and higher expenses during their 30s and 40s when they have children at home. Also, experiencing unsuccessful businesses for several years is very common before starting a better earning trajectory. Achieving the desired ratios is often not a linear process. The fifties and sixties offer excellent opportunities for many to strengthen their earning potential and boost investment rates.
Sound Retirement Income Score
While the financial independence number provides a technical measure of retirement readiness, it's not the only metric to consider. Some people may also want to consider how comfortable they feel spending money during retirement. Many people are more comfortable spending income (from Social Security, Pensions, and possibly rental properties) than selling assets to cover their regular expenses during retirement.
The Sound Retirement Income Score takes this into account: it divides your income from guaranteed sources by your essential expenses during retirement. A retirement budget calculator actually looks over the decades of your intended retirement to come up with this calculation.
In this case, you should aim to have at least 80% of your essential (non-negotiable) expenses covered by guaranteed income. If your sound retirement score is well below the 80% threshold, you may have options to boost it before retirement. For example, paying off your mortgage and all other debts before retirement can lower essential expenses. If you have a large nest egg. you may want to convert a portion of your assets to a guaranteed annuity to boost income.
Debt to Assets Ratio
A total debt picture becomes really important within the 10 years prior to your intended retirement year. Of course, it's optimal to be debt-free upon retirement since having lots of payments can make it hard to enjoy the luxuries that make retirement fun.
Paying off debt before retirement is as important as avoiding additional or excessive debt before or during retirement. While buying a new vacation home, a new RV, or helping children pay for school may be important to you, these purchases can be tough on the retirement budget.
As a rule of thumb, aim to keep your debt-to-assets ratio below 20% as you approach retirement. Your debt is your total debt load - mortgage balance, auto loan, student loans, credit card balances, etc. Your assets include everything that is invested in either cash or other financial securities like the stock market or real estate.
People with higher debt loads may want to work a bit longer to address those debts or consider downsizing their housing to free up cash to lower their debt.
Are you preparing for financial independence?
Whether you’ve heard the term or not, aiming for Financial Independence before retirement is a worthy goal. It can help you get the most out of your retirement years - allowing you to spend less time worrying about finances and more time living a meaningful life.
Start tracking your financial independence numbers today, so you can retire with more confidence down the road.
Next, we'll explore physical independence - the ability to engage in all the activities you aspire to and what you can do to increase the odds of remaining physically healthy and capable long into your retirement years.