The basic rules to follow to financial independence and early retirement

I don’t know why – maybe it is changing jobs recently or maybe it is the fact of getting older that this subject of financial independence and / or early retirement (from the corporate world) has been something I’ve really been thinking about a lot lately.

I did write an article about early retirement a while ago and it seems to be the most popular article on this blog. So obviously a lot of people are thinking about it.

I’ve talked about sites that I visit regularly like www.financialsamurai.com or www.mrmoneymoustache.com – these guys are writing in way more detail about their shift out of the corporate world into the world of having your money work for you and achieving financial independence. They both saved at high percentages of their after tax net income for several years and both managed to walk away from their day jobs before 40. An amazing achievement and quite brave, given most people will need to work until 70+ to have a comfortable retirement. Brave as a lot can go wrong in the 60 or so years they probably still have to live off their savings.

Obviously neither of them has really stopped working, they both have successful websites that provide probably more money than they were making in their day jobs or at least they have steady revenue streams now that means they don’t have to rely on their bank accounts and investments.

This isn’t a given to everyone who is thinking about financial independence or retiring early.

The golden rule is that you should have enough money set aside that when you multiply it by 4%, the number you get to should be more than what you are living on now plus tax. Let’s look at an example:

If you earn 3.000 euros gross a month, that works out to the following net of taxes (approximately):

Gross                    : 3.000 €

Social charges   : – 720 €

Net                        : 2.280 €

Taxes                    : -500 €

Available             : 1.780€

So if we assume you need the full 1.780€ to live on per month that equates to 21.360 euros a year. Divide that by 4% to get your magic number and you get to 534.000 euros of required savings. That’s the amount that at a 4% return rate should generate enough money to cover your 1.780€ expenses every month and you’ll never need to use any of the capital.

But wait, what about taxes? Your 4% return will still be taxed. So to be simple, lets use the 2.280€ a month as the number to cover. That equals 27.360 per year and the magic savings number becomes 684.000€.

But that’s really simplistic as I haven’t factored in travel expenses or the renovations to your home or paying medical insurance (which would be included in the social charges in the above example). I haven’t included kids schooling or any other one-off things, like replacing a car, that might happen in the future. All of those will have an impact and need to be factored into your magic number.

So you can see that much more thought needs to go into arriving at your magic number. The best way is to annualize your monthly expenses and then to add on the extra amounts that you may need, like house renovations, school charges, holiday travel (especially that once retired you may want to travel a bit more.

Once you get a revised annual number you divide it by 0.04 (4%) and the revised magic number appears.

Simple as that.

But hang on why 4%?

This is an estimate of what you could reasonably expect to earn on your money long term. Let’s look at some asset classes:

S&P 500 (US broad based stock index)

From 1871 to 2017, the S&P 500 returned about 9% per year. If we adjust out inflation (the growth coming from generalized price increases) the return was about 7% per year. That’s the average, as some years it lost money and some years it gained money. The key here is the word long term. If you had been invested since 1971 and looked at your portfolio now, you would see growth of 7% per year, factoring out inflation. That’s pretty good. Even more recent returns, last 17 years as an example, are also around 7% per year.

And Europe?

In France over the same long term time period, you would have earned on average 3%, in the UK 5%. So important here is not to have everything invested in one country but to be diversified.

How about other returns?

The US real estate market returned 11% annually between 1970 and 2016. Not bad. However between 2005-2017 house prices in the US rose on average by 2%

And Europe? Between 1994 and 2017 European Real estate has returned an average 4% return according to the MSCI Europe Real Estate Index. This refers to real estate companies. And actual prices of real estate? Between 2005 to 2017 average house prices (per Eurostat) increased on average 2%. That’s about the same as the US and close to the general inflation targets most countries have. Essentially it is true that housing tends to be an inflation hedge.

So you may see by the large disparity in return rates that the 4% is not such a simple number to use. It, like anything, else is a broadly accepted statistic to use, but one that needs to be used with caution. It is based on historical returns, but future returns could be either much higher or really lower. So use it as a guideline.

I would recommend you use 4% but also look to see if you can get the magic number to work at 3% to be as safe as possible.

Happy Financial independence and early retirement!

TheCFO

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