The life expectancy for a newborn baby in the United States is expected to soon reach eighty years.1 Although life expectancy varies by gender and other factors, this means that the typical baby born in the 2020s can reasonably expect to see the dawn of the 22nd century. Eighty years might seem like a long time, but it is just over 29,000 days, and just a sliver of time in the context of human existence. Our lives are brief and transitory and our most precious resource is our limited time. Wealth can purchase many things, including better health and longevity, but no millionaire or billionaire has yet been able to purchase immortality. However, what wealth can do is to provide us with control over how we spend our limited time by relieving us of having to trade our time for income unless we choose to do so for non-monetary reasons.
The goal of financial independence is best viewed as a means to an end rather than an end in itself. Simply defined, financial independence is achieved when a person can generate a stream of cash flows from accumulated assets that exceeds his or her spending needs. It is easy to see that there are two sides to this equation and that there is no specific “magic number” that translates into independence for everyone. The level of wealth that implies independence for a person of modest needs could be $1 million or less while a person of very expensive tastes could require tens of millions of dollars and still not find it to be enough.
If you ask most Americans how much they need in order to achieve financial independence, the response will almost always be given in terms of the level of wealth that they aspire to accumulate. However, thinking about the problem in this manner has a number of deficiencies. The primary issue is that it is not the level of wealth that matters as much as the cash flow that can be safely drawn from that wealth every year.
When aiming to achieve a goal, it is important to focus on what the goal actually is, and that goal is not being able to look at a net worth figure but to fund expenses and to be relieved of having to trade precious time for income.
Have you ever noticed that when you ask a Britisher about a man’s wealth you get an answer quite different from that an American gives you? The American says, “I wouldn’t be surprised if he’s worth close to a million dollars.” The Englishman says, “I fancy he has five thousand pounds a year.” The Englishman’s habitual way of speaking and thinking about wealth is of course much closer to the nub of the matter. A man’s true wealth is his income, not his bank balance.Where Are the Customers’ Yachts, p. 149-150
I find the British manner of thinking about wealth much more satisfactory for several reasons that are worth exploring in greater depth.
Focus on Spending
The simple fact is that financial independence is more attainable for someone with modest needs who avoids the ratcheting lifestyle trap. Especially during the early years of accumulating capital, the most important factor facing a younger person is how quickly to ramp up spending as his or her income increases. The standard approach taken by almost everyone is to consume the vast majority of income and to increase spending as income increases.
Most personal finance articles urge people to save a certain percentage of their income. In recent decades, personal savings has been pitifully low and rarely has approached ten percent.2 Generally, saving 10-20 percent of income is considered a healthy level. The problem is that this implies a consumption rate of 80-90 percent of income and also implies that it is acceptable to increase consumption as income rises. This is not a path to financial independence.
A few years ago, I wrote an article proposing that a married couple earning $100,000 per year could theoretically achieve financial independence within fifteen years starting with no savings at all. What was the catch? The after-tax savings rate for the couple would need to be around 55 percent, which is obviously far in excess of what is considered normal. What about a 10 percent savings rate? The couple would not be anywhere close to financial independence even after thirty years!
Obviously, the amount saved at a 10 percent savings rate will be far lower but the other side of the equation is that the level of spending the couple needs to replace is much higher. The gulf between spending and passive income is simply too large to overcome.
Avoid Fixed Magic Numbers
Let’s say that a person decides that he needs $2 million to be financially independent based on his desire to spend $60,000 per year and his belief that drawing down 3 percent of his portfolio annually can be done safely on a long term basis. Should he mentally anchor to the $2 million or to the $60,000?
Anchoring to the fixed $2 million number is not helpful for a number of reasons. Perhaps most importantly, the $60,000 income requirement will not remain static over time simply due to the rising cost of living. The Federal Reserve has explicitly stated that their inflation target is 2 percent and it is certainly possible that inflation will run much higher than that over time. Ten years from now, the income requirement will be over $73,000 to maintain the same purchasing power as $60,000 today assuming that inflation runs at 2 percent.
The prospect for returns on financial assets also changes over time. For a long time, many financial advisors advocated a “4 percent rule” — that is, conventional wisdom was that an investor could draw down 4 percent of a balanced portfolio of stocks and fixed income securities indefinitely without having to worry about running out of money. With interest rates on fixed income securities plummeting in recent years and stock valuations at elevated levels, it may no longer be conservative to draw more than 3 percent per year. This may change in the future. If a safe withdrawal level returns to 4 percent in the future, the investor may need less than the $2 million number. If the safe withdrawal level declines to 2 percent, on the other hand, more than $2 million will be required.
Sustaining the Long Term Effort
Going back to the couple earning $100,000, the pursuit of financial independence over fifteen years would be a long term effort and maintaining a very high savings rate for a long period of time is not psychologically easy. There is a risk that as the couple’s portfolio value increases past various milestones, they will feel “wealthy” and be tempted to increase spending.
During the accumulation phase, it is very helpful to not think in terms of net worth milestones. For example, reaching the six figure savings milestone is a major event for most people. $100,000 still represents a very significant amount of money and, while it isn’t a huge amount of wealth, it can make someone feel relatively well off.
Instead of thinking of having $100,000, the couple should instead think of having $3,000 of untapped passive income potential, assuming that they are targeting a 3 percent withdrawal rate. Viewed in this way, the $100,000 is really not a huge amount relative to the income needs that the couple aspires to fund. They are still at an early stage of their accumulation phase.
Rather than going out and buying a $40,000 car, the couple might instead spend $100 on a nice dinner to celebrate the milestone and keep focusing on the long term target of financial independence.
Money can be an emotional topic full of psychological pitfalls. Much of the battle when it comes to achieving financial independence is really an adult version of the famous “marshmallow test” in which children are given the choice of consuming one marshmallow immediately or waiting a short period to be able to consume two marshmallows.
There are some people who are relatively immune to the impulse of ratcheting up their spending as income increases but most people will succumb to the temptation. A check on that temptation will exist if we think about financial independence in terms of being able to generate an adequate passive income sufficient to fund the spending that we are accustomed to.
The fact is that a person who ratchets up his or her lifestyle and goes from needing $50,000 to $100,000 per year has dramatically lengthened the time required to achieve financial independence. This is not to say that all spending is ill advised or unjustified. We should just be sure that when we ratchet up our spending, we fully understand the implications of financial independence being further out on the horizon as a result.
- See Living Longer: Historical and Projected Life Expectancy in the United States, 1960 to 2060, published by the United States Census Bureau in February 2020.
- See Personal Saving Rate data series published by the St. Louis Fed.