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How Much Do You Need to Reach Financial Independence?

Becoming financially independent (FI) is a dream for many investors. The idea of walking away from your job to do whatever you want with your time can be an incredible motivator. But what amount of money does it take to make the dream a reality? On a Fool Live episode recorded on Feb. 19, Fool contributors Brian Feroldi, Jason Hall, and Brian Withers discuss the most common rule of thumb for calculating your FI number and what else you should consider.

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Brian Withers: Let's talk a little bit about the math. Generally, the definition to be FI [financially independent] is when your investments and net worth are equivalent to 25 times your annual expenses. That's generally a definition that's out there. It goes along with what's been dubbed the four percent rule. I'll throw a couple of links in the chat. The four percent rule was looking at a portfolio of 60 percent stocks, 40 percent bonds over a 30-year life, you could pull four percent out of the total every year, and you would be, I think, in the high 90s percent certain that you wouldn't run out [of money] over a 30-year retirement.

There's certainly a lot of caveats to that. How do you guys think about, what is the math for you? Is there a certain target that you're hitting? How do you think about what's the FI number is that you're trying to achieve?

Brian Feroldi: I'll go first, I guess.

Jason Hall: Yeah, go ahead, Brian. [laughs]

Brian Feroldi: I think that it's a great rule of thumb. Just like having a rough rule of thumb out there in the world is very helpful. To me, one of my favorite bloggers is Mr. Money Mustache, Pete Adeney from Colorado. He was the one that really hammered this home for me. One of the things that he said that really aligned to my thinking with this is, people always think that your financial independence number is some number, like it's like a million, two million, five million, 10 million, and if you ask the average person on the street, what's your FI number? They'd be like 10 million or some ridiculously high number because it seems like impossible to achieve it.

What he did is he said, "No, it's not." The way to calculate it is just whatever your expenses are, times 25. It's a function of your spending, not a function of your net worth. Your net worth could be 500k and you could be at FI if your lifestyle was cheap enough, and other people could be, they have to get to 20 million before they got to that number. It all depends on what their spending level is. I think 25 times your annual spending is a fine rule of thumb, but there's all kinds of caveats that are in there. That number was made on a calculation from way back when about what the portfolio withdrawal rate will be. I think it was maybe like 1996.

Jason Hall: It's the flip side of the four percent rule. That's how it works the other way around to get to [inaudible], yeah.

Brian Feroldi: Exactly. That was I think made in like 1996, 1997. I looked back on historic data. Interest rates currently are at zero. What kind of returns can you expect from your bonds? What's inflation going to be? All that kind of stuff.

Other people look at that number and say, "Way too conservative. You can't do it until you're at 30, or 33, or 35 times your rate." I think that that is perfectly logical. Other people say that's way too much. If you need to get to that number, that's way too much, and that you can get there with 10 times your annual spending.

I think that, again, it's a great rule of thumb, but there's so many thing that that number doesn't include, which is like what are your future expenses going to be? Are there any future sources of income that you have? That number is based on zero future income, zero. I know a lot of people that are financially independent. I don't know any of them that makes zero. [laughs] Their income might fall dramatically, but it doesn't go to zero. But you're assuming that it is going to go to zero forever.

If you are the type of person that if you agree with what I said before about financial independence, and it's really about quitting a job you hate, and taking one that you love that has all kinds of optionality into it, and you could take out 75 percent haircut on your pay to do that, let's say you go for making a 100k per year down to $25,000 per year, that's $25,000 per year that you don't have to fund through your nest egg. All of a sudden, the amount of money that you need falls dramatically. I think it's a great rule of thumb, but like anything, there's some bazillion caveats.

Jason Hall: Yeah, I agree with that. Again, that's where I think you have to be careful about just planning and some projecting expenses today and then using some sort of a fudge factor to increase them. You have to think about, it's just like with your portfolio, the reason you diversify your portfolio is you want to make sure you don't have extreme exposure to the downside of one individual company and one of them happening that makes that company worthless.

It's the same way, you have to think about it. You invert that and think about, is there one potential event that could occur in your life? For example, cancer diagnosis, a devastating car accident. Some sort of thing that could result in enormous expense that would affect whether or not your existing nest egg truly would allow you to be financially independent.

I think you have to think about those worst-case scenarios too and not just plan it around some warm and fuzzy, this is the perfect number that gives me the ideal lifestyle. You just have to plan for a margin of safety.

Brian Withers: Yeah, I'd tag onto that. I call this fuzzy math. If you're not traveling today, and you want to travel in the future, and that's a big part of what you want to do, you should figure out what that's going to cost you.

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