The idea behind becoming Financial Independence (FI), or financial independence retire early (FIRE), has always been simplified down to this. Work out how much you need, or want to spend in a year. Then multiply that by 25 to get the size of the diversified investment portfolio you need. In theory, this will allow you to use the 4% “safe withdrawal rate” to draw down on your portfolio, and due to the compounding nature of your investment- you shouldn’t ever run out of capital.
Ok, so you work out that you need roughly $40,000 per year to live a comfortable life. That means that you will need to set aside an investment portfolio of 1 million dollars. The $40k value is arbitrary here- if you need less money than that- your portfolio size can be smaller, making FI more achievable.
Anyway- the problem isn’t the size of the portfolio you need- the problem is that 1 million dollars today isn’t the same as $1 million when you retire. By the time you retire- you will need more than 1 million of today’s dollars.
That is down to inflation. Inflation means that the value of your money is greatest at the time you earned it. In other words, your money will buy you less stuff in the future.
Inflation accounts for the average increase in prices throughout the economy. In New Zealand- we don’t track total inflation- rather we track The Consumers Price Index (CPI) which measures changes to the prices of the consumer items you buy. The CPI doesn’t include house price inflation, but it does provide a measure of household inflation.
How Inflation Impacts your FI Calculations
Back to the example and how Inflation will impact the calculation:
- You have worked out that you need $1,000,000 (one million dollars) in savings to generate an annual income of $40,000 (assuming a 4% safe withdrawal rate) for your to be financially independent.
- You intend to quit your job to pursue other challenges in 10 years.
The question then becomes, how much will a million of today’s dollars be worth in 10 years? And how much do you really need to have saved in 10 years to generate the equivalent 40k annual income you need in today’s money?
To work these questions, we need to know the value of inflation in the next 10 years. Working out what inflation will be for the coming decade is like predicting future returns based on past performance.
Consumer Price Index 2000 to 2021
The consumer price index over the last 20 years has been, on average, 2%. At times, it has risen to above 5%, and below 1%. So a value of say 3% might be appropriate as an estimate of what the next 10 years will be. Also remembering that the reserve bank is mandated to try and keep CPI around 2%.
For this example, let’s say that average inflation is at 3%.
To have the equivalent of today’s $1,000,000 in 10 years, you need to have invested $1,343,916. This will generate you a safe withdrawal rate of $53,756- which has an equivalent spending power in 10 years as $40,000 would today- assuming inflation on average is 3%.
This is why it is important to save money and make sure that you are getting a return on your money that is higher than the current inflation rate. This is quite hard to do if you are looking at using term deposits- which are only around 1%. Effectively, your money in a term deposit is losing true value due to inflation.
So in reality- the FI calculation is not as simple as it seems. You probably need to save more than what the 25 times rule suggests.
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