Retirement can be defined as achieving financial independence in the third stage of life – typically after age 62 when you can claim Social Security.
There’s also a rapidly growing movement around FIRE (Financial Independence Retirement Early) where people aim to achieve financial independence and gain complete control over their scarcest resource, their time, at a much younger age. There are multiple FIRE communities with tens of thousands of people online who are trying to achieve financial independence in 10-15 years vs a traditional career of 40 years; one of the most active is ChooseFI. There’s even a movie coming out about it in 2019 “Playing with FIRE”.
It’s worth noting that early retirement is still the exception with less than 1% of the population retiring before 50.
What is Financial Independence
JD Roth, one of the original personal finance bloggers, defines it this way: “ Financial Independence occurs when you’ve saved enough to support your current spending habits for the rest of your lifewithout the need to earn more money. You might choose to work for other reasons – such as passion or purpose – but you no longer need a job to fund your lifestyle.”
He’s even written a handy article on the six stages of financial independence – which is a great way to break down the problem and assess your own progress.
- Stage 1 – Solvency (you can pay for yourself but use bad debt)
- Stage 2 – Stability (you don’t have bad debt like credit cards)
- Stage 3 – Agency (you’ve got enough savings to choose the work you prefer to do)
- Stage 4 – Security (your investment income covers basic needs)
- Stage 5 – Independence (your investment income maintains your standard of living)
- Stage 6 – Abundance (your income starts funding additional goals)
How to Achieve Financial Independence
To answer the question of how to achieve financial independence it’s worth examining the approach taken by the FIRE community since they have a bigger hurdle than traditional retirees, because they can’t yet use Social Security or Medicare and have to fund a longer time period.
So let’s look at the method used by FIRE and then we can explore some of the additional levers that traditional retirement people can use.
The FIRE method basically comes down to a few core ideas – cut your expenses, save > 50% of your income and invest efficiently. Frugality is key for FIRE and you’ll see why below.
The typical approach to achieving FIRE is:
- Track your expenses: it sounds simple but many people have no idea where their money goes and many don’t want to look. A simple way to do this is charge everything, pay it off in full every month and then look at what your spending money on. Many credit cards offer this or you can use tools like Mint.
- Cut your spending: a great way to approach this is to first shift your mindset – look at it as getting control and celebrate how frugal you can be vs. comparing yourself to the Jones’. Start with a one month exercise to see how little you can spend. If you start questioning everything you’d be surprised at just how much you can save. You’ll also discover the joys of your local library, parks and bike paths!
- Calculate your financial independence number: the FIRE rule of thumb is 25 times your expenses, which is based on the 4% withdrawal rule. Whether that number is truly safe is another whole article. If you want to be safer or potentially live larger – shoot for 30 or 35 times your expenses. This number can get very big if you spend over $100K per year, which is why keeping your expenses super low is core to FIRE.
- Get tax efficient: there are a lot of moving parts to this, but basically you want to save and capture market returns as tax efficiently as you can both now and in the future. This is another place that having low expenses matters. Many FIRE people they can save in qualified accounts while working to lower income taxes, then convert some savings into ROTH IRAs once they achieve financial independence and hopefully be in even lower tax brackets (since their expenses are low).
- Invest aggressively and efficiently: since FIRE people are younger and have more time to recover from down markets if they need to; the key is to invest and capture the market returns as efficiently as possible. For this reason many FIRE people pursue a passive strategy where they invest in a very broad well diversified portfolio with very low fund expense ratios. Additionally many FIRE people invest in real estate since it can provide long term reliable cash flows.
Traditional Retirement Method
Even though FIRE is hard to achieve and may by very hard for people with children, special needs or who live in HCOL (high cost of living) areas, there are still lessons for folks pursuing traditional retirement.
Traditional retirement provides for some key benefits for “older” people since they can take advantage of mortality credits – basically the fact that they have a shorter life expectancy means higher benefits in programs and products like Social Security, Medicare, Annuities and home equity products like Reverse Mortgages.
The retirement planning method that we follow at NewRetirement is:
- Think through your goals & values: writing down a specific vision for what you want your future to look like will help you make it a reality. Understanding your goals and values will help you frame and make the important trade off decisions during your journey to financial independence.
- Figure out what you need and want to spend: create a budget with minimum and desired spending levels based your spending habits. A huge driver of this is often where you live, state and property taxes.
- Document all of your resources: this should include not just your retirement savings and investments, but also any pensions or annuities, military or federal/state benefits, your home and home equity, human capital (willingness to work part time), plan for claiming Social Security and other assets like second homes, small business and insurance.
- Explore ways to fill the gap: figuring out how to coordinate using ALL of your assets isn’t trivial since how you use one asset can often impact other parts of your plan. For instance, if you claim Social Security at age 62 and work part time, then roughly every dollar you make over ~$16,000 per year reduces your Social Security benefit. Another example is the order and type of assets (qualified or non-qualified) you draw down may have significant tax implications.
- Take action: once you come up with your working plan either on your own or with a financial expert who is a fiduciary like a Certified Financial Planner™ then it’s time to implement your decisions. Since some of these decisions can only be made once it can be worth it to review your plan with an expert fiduciary financial advisor – there are increasing numbers who will do this on a fee only basis.
- Monitor & manage: retirement planning is not one and done; your life, taxes, markets and benefits programs will continue to change over time. Managing expenses can help people who are late in their savings years if they are off track or behind. Moreover, the flexibility and ability to cut expenses could make an unviable plan viable or to correct course and save a plan while in retirement. You should expect to monitor and review your plan at least annually – especially with a retirement that could last 30 years!
The good news is that the body of knowledge about how to plan and achieve a secure retirement is growing. As more people enter retirement the market is getting more efficient with lower fees and more transparency across the board. A great way to get started is to use a simple retirement calculator to see where you stand and take the first step.