Have you recently stumbled upon the FIRE movement? Contemplating if this path could be for you? If so, you may be wondering how much money you really need to retire early. In this post, I’ll show you how to determine your Financial Independence (“FI”) number, as well as share ours.
Additionally, as promised in Part 1 of the FIRE Guide series, I’ll show why you don’t need a six-figure income to achieve financial independence and retire early. If you haven’t already, check out How to reach Financial Independence Without a Six-Figure Salary.
How much do you really need to retire early?
This is an important question, but I’m sorry to say, there is no one right answer. No one can predict the future of the markets or the cards that life will deal you. However, there are short cuts to estimate how much you’d need to live off your investments for the rest of your life. This amount is referred to as your FI number. And as Chris Hogan often says, “Retirement is not an age, it’s a financial number.”
There are several ways to determine how much money you need saved for retirement. We’ll discuss two of the most common (one I recommend, and the other I do not).
Method 1 – Your retirement plan’s website (the 85% rule)
If you participate in a 401k or other retirement account, you’ve likely seen prompts when you log into the website telling you how much more you need to save for retirement. Most sites provide calculators which will tell you “how much you need to save to retire”. But should you rely on that number? In my opinion, these tools are usually inaccurate.
Most brokerages base these calculations on replacing 85% of your current income. This is an old-school rule. If you are saving 20% or more of your current income, as many in the FI community are, this method is not for you.
If you have a high savings rate, these tools will provide an inflated retirement goal, which will require you to work longer. I still get frustrated when I log on and it tells us we need $12,000+/month in income. We don’t need that much …not even close. And a calculator that takes expenses into account would know that.
Method 2 – The Trinity Study (the 4% rule)
I recommend that you use the Trinity Study, also known as the 4% Rule, to determine your FI number. This is also the method that most members of the FIRE community use and recommend.
What is the Trinity Study?
The Trinity study refers to a paper that was published by three Trinity University professors in the 1990’s on the determination of a safe withdrawal rate from diversified retirement portfolios. The study evaluated several different stock/bond mixes and withdrawal rates against market data over payout periods from 15 to 30 years. It found a 100% success rate in most scenarios using a withdrawal rate of 4% or lower. Even portfolios as conservative as 25% stocks and 75% bonds outlasted the hypothetical retiree over a 30-year period with this withdrawal rate.
The 4% refers to the portion of the portfolio withdrawn during the first year; which can be increased in subsequent years to keep up with inflation using the consumer price index (CPI).
Is the Trinity Study still relevant today?
While the original study only utilized market data through 1995, it has since been updated for returns through 2009, with the original conclusions upheld.
Some critics challenge the 4% withdrawal rate in today’s low interest rate environment. Returns on treasury bonds averaged 3.5% to 4% at the time of the study, while today they are below 1%. I understand why this would raise questions, but I still believe its tenants to hold true.
With bond rates as low as they have recently been, a 25% stock/75% bond portfolio would likely have a lower success rate today. However, the 4% withdrawal rate is still well below the historical Compound Annual Growth Rate (CAGR) of the stock market, which averaged 10.6% from 1989 to 2019. (Note: Average annual returns, which were over 12% during this time, also include returns of principal from down years, so I prefer CAGR). As such, the 4% rule should still hold true, but you may need a more aggressive portfolio.
Does the Trinity Study work for early retirees?
The other challenges I see with this study, are in relation to the early retirement community. The original study tested payout periods up to 30 years, but what if you want to retire early? You might need that money for 40 to 60 more years. Again, the 4% rule should still work as long as you ensure your portfolio is aggressive enough.
If you withdraw 4% of a portfolio that has an average return of 5%+ you could, in theory, never touch your principal and live off the gains. Obviously, that’s not how the market works. There are ups and downs. The biggest risk to your portfolio is a down market in the early years of retirement. This scenario might force you to draw principal too fast and too soon.
You can adjust for this risk by maintaining flexibility to reduce expenses if needed, having adequate cash reserves or income producing investments to support you in early years, or by selecting a withdrawal rate of less than 4%. The longer the payout period, the more aggressive the portfolio or smaller the withdrawal rate should be.
Calculating how much you need to retire early
Step 1 – Figure out your annual spending requirements
In order to calculate your FI number, you first need to determine what your lifestyle costs each year. This is where having a budget or tracking your expenses comes in handy. While your expenses in retirement may differ, current annual expenses will be the best starting point for this calculation.
Once you know current expenses, you can adjust as needed to get to your expected expenses. You might include decreases for transportation and clothes but increases for health insurance and travel. Think about your desired lifestyle in retirement and what changes in your current expenses that might entail.
Another expense to consider, if you own a home, is your mortgage. Some people include the whole mortgage payment in their calculations, while others just include the interest or omit it altogether. Do what makes you most comfortable. Just don’t forget to include property taxes, insurance, HOA and maintenance costs, since those never go away while you own a home.
You could also reduce your future expenses down for any additional income you expect to receive, such as a pension or social security income. Whether or not you should actually do so depends on the certainty of the income and when those income streams will become available to you.
Step 2 – Choose your withdrawal rate & calculate
Once you know your expected annual expenses, you can use some simple math to come up with your target FI number. You could also use one of many FIRE calculators online.
Now you need to choose your withdrawal rate. As discussed above, 4% is the rate most commonly used and should provide a safe level of withdrawal. If you choose this rate, you would calculate your FI number by multiplying your expected annual expenses by 25. Similarly, a 3% withdrawal rate equates to 30x annual expenses. There are also calculators online that can help you adjust this for future one-time payments (like college tuition).
Alternatively, if you love spreadsheets like me, you could build out a forecast of all future income, expenses, inflation, and growth. Yes, this approach is tedious and only for the super nerdy. But I’m a control freak and this lets me tailor expenses and income each year rather than smoothing them out. It also lets me test out my FI number, and play with assumptions to determine in which scenarios our portfolio will outlast us. We’re aiming for age 100. For most people, the short cut method or online calculators will be much less time consuming and just as satisfying.
But what about inflation?
This is the question a family member asked. Yes, inflation will impact future expenses. However, while you’re still working and growing your portfolio, you will also receive the benefit of inflation in your paycheck through increased wages. Additionally, the Trinity study allowed for increases in annual withdrawals for inflation each year, with some historical rates well above recent years and the Fed’s target of 2%.
If you’d like to add cushion for inflation, you can easily do so by reducing estimated market returns by 2%. Could inflation be higher than 2% in any given year or for many years? Sure, it could. However, returns in the stock market could just as easily exceed the expected returns used in your calculation. Moreover, the stock market is very likely to continue to beat inflation by some margin. If prices for goods and services go up for you, then revenue is going up for the companies producing the goods or providing the services, which will lead to continued growth in the market.
It’s hard to say if the same will be true about bonds, especially with the Fed’s current stance. Though, there’s a lot of conflicting information. It seems if bond yields were less than inflation over a length of time, people would just hold cash or throw more money in the market.
I recommend that you update your calculation at least annually with current expense estimates. This will update for inflation in real time.
Calculating our FI Number
We will consider ourselves to be financially independent once we reach $1,250,000 in liquid investments.
UPDATE: We’ve revised our estimate since writing this post. We will now consider ourselves to be financial independent once we’ve accumulated $1,000,000 in liquid investments.
Our current annual expenses are around $55,000/year; however, we expect these to be about $5,000 less once Mr. RFL joins me in early retirement. In calculating our expected annual expenses, we’ve adjusted our current expenses to remove daycare and mortgage costs which we will not have in retirement, and to increase health insurance costs since we’ll no longer have subsidized medical care through work.
Here’s what our FI number looks like at varying withdrawal rates:
| Withdrawal Rate | 4% | 3.5% | 3% |
| Estimated Monthly Expenses | $50,000 | $50,000 | $50,000 |
| Multiple | 25x | 27.5x | 30x |
| Financial Independence Target | $1,250,000 | $1,375,000 | $1,500,000 |
We are comfortable using a 4% withdrawal rate since we’ll have two future income streams that are NOT included in our calculation. We both have small pensions from a former employer which should pay out around $10,000 per year if we wait until full retirement at age 62. There is also an option to receive reduced payments at age 50, should we need the money. Additionally, we’ve both worked long enough to earn full Social security benefits. However, given the current state of the program and fact that we’re retiring in our 30’s, we’re not expecting much help from the government.
The average American household’s path to FI
According to the US Bureau of Labor Statistics’ (BLS), the average American household spent just over $63,000 in 2019. Median household income was $68,703 according to the U.S. Census department’s annual report on household income also published in September 2020. Although these figures come from different reports, the net savings rate aligns with the personal savings rate of 7.9% reported by the U.S. Bureau of Economic Analysis (US BEA) in its January 2020 Personal Income and Outlays report. As such, we’ll use $68,700 in income and $63,000 expenses in our analysis below. (If you want to see how that $63,000 was spent, check out our post on average American household spending).
With annual expenses of $63,000, the average household would have a FI number of $1,575,000 million using the 4% rule. If we assume a starting point of $0 net worth, and $68,700 in income (or a savings rate of just over 8%), along with 6% investment growth and 2% inflation, the average American household won’t reach financial independence for 62 years!
It’s possible to reach FIRE without a six-figure salary!
If instead of spending $63,000 per year, the average American household spent only $50,000, the time to FI would be cut in half (33 years)! At a lower spending rate, not only is the financial independence target lower ($1,250,000), but the savings rate has also increased to over 27%. This spending level is easily doable for most families with little to no deprivation required.
While 33 years is still a long time, a 22 year old would reach financial independence by age 55. They could still retire early by conventional standards. Additionally, you could speed up this timeline by spending less, making more or achieving better returns on investments.
You can control your speed to financial independence. There are many levers that can be pulled, even if you aren’t taking home a large salary. If you make less, than obviously you’d have to spend a little less to retire early.
Below are a few other scenarios to demonstrate how FIRE could be achieved on a lower salary. For simplicity, each assumes a starting age of 22, net worth of $0, 6% market return, and 2% inflation. Feel free to test your own scenarios using Mr. Money Mustache’s calculator.
A few more examples…
| Salary | $68,000 | $40,000 | $90,000 |
| Expenses | $35,000 | $30,000 | $40,000 |
| Savings | $33,000 | $10,000 | $50,000 |
| FI Number | $875,000 | $750,000 | $1,000,000 |
| Time to FI | 18.1 yrs | 34.7 yrs | 14.7 yrs |
| Retirement Age | 40 | 57 | 37 |
The point of this is:
- Financial independence CAN be achieved by someone with a moderate salary, without living a life of deprivation
- You should actively plan for and pursue financial independence if you want to retire at a reasonable age. The “average” American consumption and saving patterns will not get you there.
Yikes, that’s a big number. How can I reach FI faster and retire early?
The only way to reach financial independence sooner is to increase your savings rate or lower your FI number. Finding ways to be more frugal and reducing your spending is the easiest way to do this. Doing so will both reduce your FI number since it’s based on annual expenses, and increase your savings rate since you are spending less on the same salary. Similarly, making more money will help to increase your savings rate. Obviously, a combination of these approaches will help you reach FI and retire early faster with the least amount of pain possible.
If you haven’t already, check out Part 1 of this series for more detailed steps and tips on how to reach FI and retire early, even if you aren’t making six-figures a year.
So, are you ready to join the movement?
