FI On Blues
The term “on blues” is used by emergency services personnel, particularly the Police to indicate the use of the emergency blue lights to get to a job at speed. I think the term works well with Financial Independence (FI). By following some simple steps, you could really reach financial independence much quicker than you think. Its simplicity makes it even more unbelievable.
A very popular and influential FI blogger called it “The Shockingly Simple Math Behind Early Retirement“. You can replace the words ‘early retirement’ with ‘living freely’ or any other combination of words to mean you no longer need to work for money. It really is shockingly simple. It is also not an art, or subjective in nature. It is based on basic maths and the numbers do not lie.
Before we start, I just want to point out that the maths itself as a number of assumptions which I touch on. You can read more about them by doing a quick Google search. It by no means guarantees you success and it may be impossible for some to achieve if you are just scraping by as it is. However, the fundamentals of budgeting and spending less than you earn is solid advice regardless of income levels.
You would have reached financial independence when your assets cover your liabilities indefinitely (or for as long as you intend to live). I know there are technical accountancy definitions for what is treated as an asset and what is a liability. However, Cashflow Cop likes to keep things simple. For FI, these assets need be something which generates a passive income and liabilities are treated as things which cost you money (expenses). A passive income is one which requires minimal effort, so you cannot include your monthly salary from your job. There is also no point treating your home as an asset to calculate when you can reach FI if your home does not generate an income. I tend to treat a home as a liability due to the costs involved to keep it. In fact, our fascination in the UK with ‘climbing the property ladder’ is the biggest obstacle to achieving FI early. This notion of having a bigger house (more than you need) results in a large proportion of the population working decades longer. It’s fine if it is a conscious decision that is made, but I doubt most people realise the consequences of wanting that bigger house. One of the ways to treat your home as an asset is if you sell it and invest the money in something that will give you a monthly cash flow boost.
Simple FI Formula:
IF (income – expenses) ≥ 0
Income is passive monthly income (or near passive as possible), such as a pension, selling off shares, income from dividends, rent from a property portfolio or online an business with minimal day to day involvement needed.
Expenses are how much money you need for a month to live the lifestyle you want.
So the formula is basically saying if you can generate enough passive income to cover your expenses, then you’ve reached FI. If the answer is a positive number, then you’re FI. If the answer if a negative, then you still need to work to cover the shortfall. Simple right? There are other formulas out there which take into account withdrawal rates, interest rates, time, compounding intervals and other variables. However, I like it best in its simplest form, which is just about having enough passive income to cover your expenses.
As you can see, there are two variables: 1) income; and 2) expenses. Increasing your passive income will help you achieve FI sooner. Likewise, so will reducing your expenses. However, doing both will really accelerate your journey towards FI. But how much do I need?
How Much Do I Need?
That’s the wrong question. Or more accurately, now is not the right time to ask it. You need to first ask yourself, what kind of life do you want? What is your why FI? There are millionaires out there and those who earn six figures who still continue to work. Why? It might be because they love what they do, but it could equally be because they have not controlled their expenses. How much you need entirely depends on how much you spend. If you spend nothing, then you need no money! The amount you save as a proportion of your income is called your savings rate. What you don’t save, is what you spend. So, before asking how much you need, first determine how much your ideal life would cost. You might need millions invested because you have a lifestyle to match, or you could need much less. What I am trying to say is only you can answer this question. Cashflow Cop will give you the information and tools to do this.
How Long Will It Take?
It depends. Getting to FI will be shorter than you think but longer than you hope. Lets continue to keep this simple. If you manage to only spend half of your employment income (money from a job) and save the rest, it means that your expenses are 50% of your income (a 50% savings rate). So after one year of working, you can take a one year break before running out of money, because you have the other 50% saved. If you were to repeat this process, then if you work for two years, would have saved up enough for a two-year break and so on. I’m not selling it to you I am? To be honest, I wouldn’t be convinced either if someone told me I had to cut my spending by 50% and work for 30 years before I can take a 30-year break. Doesn’t sound too different from a traditional retirement plan in terms of the amount of time you need to work (except you would most likely retire with much more money). I am taking this one step at a time, so this example makes two very important assumptions: that you are saving the money instead of investing it in an income producing asset and that it completely ignores the power of compounding.
So what exactly is compounding? This is where interest is earned on top of the interest already accumulated. Using easy numbers, if you saved £1000 a year for ten years, assuming you received no interest, then in ten years you will have £10,000. However, that £10k would most likely be worth much less due to inflation. So if inflation grew at 2% per year, every year, your £1000 would actually be worth less. That’s because the cost of things has gone up, so you are getting less with every pound you spend. By your 10th year, your £10k would be worth less than £9,000. That’s just with a 2% inflation rate (see working out here). Can you see how compounding works against you in such an example?
Now, if you invested your money so that you get a return of 5%, using the same principle, but in reverse, your £1,000 a year would be worth over £13,000 (see working our here)! So in this example, the rate increases 2.5 times (from 2% to 5%), but the effect on your money triples (£3,000 difference versus £1,000 difference). If you were to allow compounding to do its magic over a longer period, then the effect is even more drastic. This is at the heart of how to build your wealth and make your money work for you.
So, let us assume your savings rate is 50%. By investing the money (instead of simply saving) and incorporating the magic of compounding, the 30 years needed almost halves to just over 16 years. This means after 16.6 years, you would have invested enough money to generate an income which would cover your expenses indefinitely, in essence, you can retire. As a Police Officer, 16 years sounds much better than 40 years. Assuming you started working as an Officer at 20 years old, you could potentially be FI by 36 instead of 60 (the age when you can claim your full Police pension). So by understanding how to save your money and invest it wisely, you could be in a position to retire in your 40s or even your 30s. If you’re earning £30,000 a year after tax, this still leaves £15,000 for expenses. The benefit of being a Police Officer is that if you keep your savings rate the same (as a % of income), you can still spend more every year because you continue to move up the pay scale. What about the pension you’ve contributed? Well, that’s just an extra bonus for you later on in life. I’ve used £30,000 a year as an example. The maths would work with any income because it is based on a percentage ratio of your income vs expenses. Of course, if your income is so low that you can barely buy food, then even though the maths still work, the reality is that you won’t be living a very comfortable life. The graph below illustrates how long you need to work based on a 50% savings rate:
The calculations above makes a number of assumptions:
1 – The average annual return on investment is 5% after inflation.
2 – You will spend on average, 4% of the value of your investment or net-worth (withdrawal rate)
This means that your investment would last forever. In fact, it will continue to grow. I will discuss these assumptions more in a future post, but the 4% spending rate is not a number plucked out of thin air. It is based on the idea by William Bengen that once your net-worth (assets minus liabilities) is worth 25 times your annual expenses, then you could be considered financially independent. It is a rough guide and should be treated as a general rule of thumb. You might decide that your safe withdrawal rate is lower, say 3.5% for example. This means you need to save more but there is less chance of you running out. The more cautious you are, the lower the safe withdrawal rate should be. By properly understanding the assumptions being made, you will stand the best chance of remaining financially independent. I’ll go into this a bit more another time.
You could really put your foot on the accelerator and reduce this down to 7 years if you manage to have a savings rate of 75%. The graph below illustrates this:
50% sounds unachievable? As a keen hiker, you don’t climb a mountain in one giant leap. It’s not possible. It is one small step at a time. In any case, who is to say you must have a savings rate of 50% to be apart of this community. Extreme frugality is not a must. So, if you decide you would like, or perhaps need to spend more and have a less aggressive savings rate, then that’s fine. Don’t feel bad about it and don’t try to compare yourself to others, be it with others in the FI community or in trying to keep up with the Joneses. Every single percent you save could be weeks shaved off how long you need to work for. There is a saying:
“Comparison is the thief of joy” – Theodore Roosevelt
Where Are You At?
So how do you monitor and mark your progress along the journey towards financial independence? I have blended the writing by Joel at FI 180 and JD Roth at Money Boss to come up what I feel are the stages of financial independence. There are others out there who have also written their own wealth scale. I feel this is an area that has not been nailed down yet, so below is my attempt along with summaries of the approaches taken by FI180 and Money Boss.
A couple of things to point out first. The journey is not a one-way street. At certain points in your life, you may find the need to take a few steps back before being able to progress further. For example, you may have paid off your mortgage but then decide to grow your family and need more space. Also, since everyone’s journey will be different, you might find that the stages mapped out below does not quite work for you or that you decide to skip a few milestones. I don’t see anything wrong in that, so long as whatever path you choose gets you to where you want to be. The milestones below are purely guiding posts to help track your progress and a good starting point to map out your own personal Milestones to FI.
- FU Money
You have a large enough emergency fund to walk away from work for a year or two.
- Half FI
You have reached half your FI number. If you are a couple, then one can go part-time.
- Lean FI
Your passive income can cover all your essential living expenses.
- Flex FI
You can pull the early retirement trigger if you are flexible with your expenses.
You have saved up 25x your annual expenses. Your passive income can cover your current lifestyle costs.
- Fat FI
This is 30x your annual expenses. It is for people who have a lower risk tolerance and allows you to have a lower withdrawal rate.
Your lifestyle depends on others for financial support. Your debt payments exceed your income.
You no longer rely on others. Your income exceeds your debt payments.
You’ve established ‘some’ emergency fund. You no longer have consumer debts (credit cards, personal loans), but may still have other debts such as mortgage and student loans.
You have zero debt and have a sufficient emergency fund to quit your job at a moment’s notice.
You have achieved financial security and your investments provide an income to cover your basic needs.
You have achieved financial independence and you investments provide an income to cover your current standard of living.
You have achieved financial abundance and your investments provide an income to live the lifestyle you want.
Cashflow Cop’s 13 Milestones to FI
You depend on debt to live your current lifestyle and have no income. This means maxing out all your official credit lines but may also mean borrowing from friends and family. You might be taking on debt to pay off older debt. You must not remain at this stage long because it could lead to financial ruin.
You now have an income which could cover some of your expenses. You continue to have debt and rely on others to live your current lifestyle. Your debt payments continue to exceed your income.
You no longer rely on others. Your income now exceeds debt payments.
Same as Milestone 3, but you now have saved up an emergency fund which could cover six months of expenses. You still have debt, but have paid back any family or friends.
Same as Milestone 4, but you no longer have consumer debt (car finance, personal loans and credit cards).
Same as Milestone 5, but you no longer have any other debts, such as a mortgage or student loan.
Same as Milestone 6, plus you have saved up two years’ worth of emergency fund. This is your first taste of freedom. You could potentially walk away from your job now and have the ability to pursue other things for a few years. You no longer feel chained down by your job.
- Slight FI
Same as Milestone 7, plus your passive income is increasing at a steady pace which could cover 25% of your living expenses, or your net-worth is about 6 times your annual expenses. You are starting to see all your hard work pay off and how you don’t need a job to earn money. You can just about see the light at the end of the tunnel.
- Half FI
Same as Milestone 8, but now your passive income could now cover 50% of your basic living expenses, or you’ve achieved a net worth of about 12 times your annual expenses.
- Lean FI
Same as Milestone 9, but now your passive income could now cover 75% of your living expenses, or you’ve achieved a net worth of about 19 times your annual expenses.
- Flex FI
Same as Milestone 10, but now you can now potentially retire early if you are flexible with your expenses and can spend a little less than you currently do. You can cover all your basic living expenses, but not quite cover your current lifestyle. Your passive income could now cover about 90% of your living expenses. Your net worth is anywhere from 20 to 24 times your annual expenses.
Same as Milestone 11, but now your passive income could now cover all your living expenses to fund your current lifestyle. Your passive income could now cover 100% of your living expenses. Your net worth is 25 times your expenses.
- Fat FI
Same as Milestone 12, but now your passive income could more than cover your current lifestyle with luxuries on top. Your passive income could now cover over 125% of your living expenses. Your net worth is 30 times your expenses.
So, how am I and Mrs. CC reaching FI in 7 years with children? See Our FI Plan. They are based on the same concepts discussed here. By incorporating the Building Blocks to FI, it allows us to maximise our income and minimise our expenses.
Where are you on the path towards financial independence? So what’s stopping you? You too can reach FI on blues!