Advanced Money School Lesson 9: Pursuing Financial Independence

Written by: David Weliver

You can spend hundreds of hours reading about money, but it’s going to be hard to turn advice into action without a clear “why”.

Why do you want to earn more money?

Why are you saving and investing?

Why do you want to become financially independent?

For many of us, freedom is a big part of our “why”. The freedom to work how and when we want to – or not at all. The freedom to travel. The freedom from worrying about unexpected bills or whether we can afford an occasional splurge.

In this lesson, we’ll tie everything together and help you finalize your wealth map with a financial freedom plan that will show you exactly how long it will take you to achieve this holy grail.

The difference between financial freedom and financial independence

Financial freedom and financial independence are two terms that are thrown around quite a bit, and sometimes interchangeably. But to me, they mean two very different things.

Financial freedom

Financial freedom means having the resources to make decisions based on factors other than money. Financial freedom means choosing the job you’ll most enjoy rather than the one that pays the most. Financial freedom means being able to take a last-minute trip with friends even though last-minute bookings can cost more than advance reservations. Financial freedom means being able to take unpaid time off, if you need to.

There are levels of financial freedom. Unfortunately, a large number of people have zero financial freedom. Economics dictates every decision, even those with disastrous consequences. They must show up for work even when they’re sick because they don’t have paid sick leave, and they can’t afford even a single day off. They must buy the cheapest food possible, which ends up being junk.

On the high end of the financial freedom spectrum is financial independence.

Financial independence 

Financial independence is absolute…you’re either independent or you are not.

When you are financially independent, you do not need to work because your assets generate your entire income.

Now, somewhat ironically, you can be financially independent while having a somewhat low degree of financial freedom. This happens when you rely exclusively on extreme frugality to become financially independent. With extreme frugality, you are technically financially independent because your assets provide a modest income, but your options are more often than not significantly restricted if your situation changes.

On the one hand, the less you need, the faster you’ll be able to reach financial independence. But you want to avoid the mistake of letting a frugal lifestyle convince you to “retire” with too little money saved. I’ll cover this more below.

Your ultimate goal should be to be both financially independent and financially free. This means your assets provide your income and you have enough income to be fairly flexible in how you live your life. That’s not to say you need to tens of millions of dollars. You can have a high level of financial freedom while living a relatively modest lifestyle. Indeed, the more modest your means, the easier this will be to achieve. You simply need to factor trade-offs (and, indeed, the unexpected) into your wealth plan so that when you finally arrive at financial independence, it does not come at the expense of financial freedom.

The idea behind financial independence

As we discussed in Lesson 2, you are financially independent when your assets generate the income you need to live and you can reasonably expect them to do so for the rest of your life.

In a traditional retirement scenario, someone who retires at 70 and has an ample 401(k) is financially independent as long as their 401(k) is large enough to meet their income needs for up to 30 years. In this traditional scenario, the retiree’s assets do not need to be so great as to provide annual income perpetually. Over a maximum 30-year timeframe, the retiree can safely draw-down the principal of their assets to meet their income needs.

Living (for the rest of your life) on just your investment earnings

If you are younger than 65 or 70, however, I don’t believe you can safely call yourself financially independent unless you can expect to live for the rest of your life on just the earnings from your investments, not the principal.

In a nutshell, here’s why:

Remember that if your money is not growing at a rate equal to or higher than inflation, the actual purchasing power of your money is decreasing. On average, money sitting in a savings account (or worse, under your mattress) loses value every year.

Investing your money in stocks, bonds, real estate, or businesses, is the best way to achieve growth that outpaces inflation. But it’s risky. Even the most tried-and-true investments experience volatility and can lose value in the short-run. As a result, I almost never recommend investing money that you’ll need in less than five years.

Over the course of decades, however, your investments should grow multiple times over. Of course, it won’t be a straight upward curving line. The stock market is a veritable roller coaster. As I’m writing this, the market is down more than 30% from its recent highs due to the coronavirus pandemic. However, as much money as I’ve lost in just the past month, I expect I will have recovered it all (and earned some more) a few years from now. How long will it take? Nobody knows. If things get really bad, it might take a decade or more. But I’m 39, so that doesn’t really phase me. If I were 69 and retired, I’d be a bit more concerned which is exactly why we recommend more conservative asset allocations as you get older – and especially when you are retired.

And this is where financial independence and the idea of retiring early gets messy.

The younger you are, the more you have to think about inflation

The younger you want to retire, the more important it is that your money continues to grow to outpace inflation and preserve your purchasing power down the line. This fact indicates an aggressive asset allocation containing 75% or more in stocks.

But both this more aggressive asset allocation and your longer withdrawal timeline make you all the more suspectable to volatility. Aggressive asset allocation will mean larger losses in down markets. This becomes doubly dangerous if it occurs earlier in your retirement because the income you withdraw those years won’t have a chance to recover in value.

I’m not saying all this to say financial independence or early retirement can’t be achieved. It can. I am saying that the younger you are, the more appropriate it is to focus on degrees of financial freedom. If early retirement is a goal, I think you need to be extremely conservative in your assumptions.

This means:

  • Assuming you’ll need more income than you think.
  • Assuming inflation will be higher than you think.
  • Assuming market performance will be less than you think.

When calculating the probability that a portfolio will be able to supply a lifetime of income at a desired level, seemingly minuscule changes in assumptions can create dramatically different outcomes. A one percent difference in just one variable: inflation rate, average annual return, or withdrawal rate – can mean the difference between running out of money and dying with millions still in the bank.

Take a look at this analysis of the Trinity Study (“the 4% rule”) to see how asset allocation, withdrawal rates, and timelines affect success rates.

Three dangerous financial independence assumptions

If you’re committed to working financial independence (FI) and early retirement, let me continue with what I consider to be three very important pieces of advice before we discuss how to create your plan.

Extreme frugality is the best path to FI

A lot of the self-proclaimed early retirement gurus promote the notion that early retirement is possible for anyone as long as your living expenses (and expectations) are low enough. If you can live on $20,000 a year, you can retire on $500,000 of investments.

First of all, I don’t think $500,000 is enough to expect $20,000 in annual income, sorry to say. (More on this in a moment.)

More importantly, I don’t think trying to retire by living on $20,000 is a good idea.

There’s no doubt about it, the more modest your lifestyle, the less you need to retire. And if early retirement is important to you, keeping your expenses in check is a must. But the more bare-bones your budget, the less wiggle room you have. Emergencies happen. Things don’t go as planned. If you retire on a $75,000 income or even a $50,000 income, you have options when you need to pay for things you didn’t expect. When you’re living on $20,000, you likely need every penny.

The point I’m trying to get across here is this:

  • The rising costs or an emergency expense will be a much larger percentage of a $20k budget than a percent of a $60k budget.
  • The more you budget to spend, the more opportunities you have to downsize/scale back your spending to accommodate unexpected expenses or changing priorities. Meaning you’ve got more wiggle room.

When it comes to planning for early retirement, it pays to moderate your expenses and live frugally. But do not rely upon extreme frugality alone to be your ticket to early retirement.

The 4% rule is all you need to know

The Trinity Study I mentioned earlier is a widely-cited financial planning research paper that shows the reliability of withdrawing 4% a year from an investment portfolio over a 15 to 30-year period.

Just as a reminder, the Trinity Study was designed to evaluate a traditional retirement in which preservation of principal was not a foremost concern as a roadmap for traditional retirees to follow enabling them to be secure in the notion they will not outlive their money.

Let’s break down the specifics of what the study does and does not say:

  • The study suggests that if a retiree withdraws 4% from her investment portfolio in year 1 and then adjusts that initial withdrawal amount for inflation every subsequent year, she will have an almost 100% chance of her money lasting for her retirement while ensuring consistent purchasing power in light of inflation.
  • Withdrawal strategy is not the same as withdrawing 4% of the portfolio every year.

That’s a nuanced difference, so let me explain.

Imagine two investors who began with $1 million invested in the S&P 500 in 1990. Investor A withdraws 4% of their portfolio every year. Investor B withdraws 4% of their portfolio the first year and then increases that withdrawal amount by 3% (average inflation) every year thereafter.

At first, the differences in these two withdrawal strategies seem small. But the end result is dramatic. Using actual returns over the last 30 years, in 2020 investor A’s portfolio would have grown to $3.2 million but Investor B would have nearly $4.7 million. Investor B withdrew and spent about $580,000 less than Investor A but winds up with $1.5 million more after 30 years.

It turns out the last 30 years were a pretty good time period to be invested in stocks, so both investors did well and have no worries about running out of money. But if markets had performed differently, it’s possible Investor A might have run out of money many years before Investor B.

Unfortunately, eager early retirees are routinely taking the Trinity Study to mean something it’s not. That as long as you don’t withdraw more than 4% of your portfolio every year, you’ll never run out of money.

This simply isn’t true.

For one, it’s a dangerous oversimplification that ignores the importance of asset allocation, withdrawal timing, inflation, taxes, and more.

Secondly, The Trinity Study was not designed for the kinds of extra-long retirements some people want today. The concept of 40- or 50- or longer retirements wasn’t really on the author’s radar!

See here for a more recent example of different portfolio success rates.

What you’ll notice is that a 4% withdrawal rate can be quite successful for up to 30 years at asset allocations including at least 25% stocks. Looking out farther than 30 years, however, 4% withdrawals start to run into trouble. Your highest rate of success comes with a 100% stock portfolio which, as you know, will be quite a volatile ride and likely isn’t practical as you get older.

This article does show, however, that a 3% withdrawal rule is much more promising. Using 3% withdrawals, all portfolios with at least 50% stocks succeed for 40 years. Even a portfolio with just 25% stocks has a 98% success rate over 40 years.

Looking at this data, it could be tempting to just say “OK, well the 4% rule should really be the 3% rule.”

If you insist on a general rule-of-thumb, I’m happier with 3% than 4% assuming our agreement on two points:

  • The only real way to ensure a successful retirement and smooth income during financial independence is to acknowledge the importance of your assumptions.
  • Flexibility may be the single largest asset to a successful early retirement.

One final point: you can always make a smaller portfolio go further if you can withdraw less when your portfolio is down (either by working more or spending less).

Financial independence will make you happy

At the risk of stating the obvious, let me say that financial independence is not some golden ticket to happiness. On the contrary, many new retirees are excited to leave work behind only to find their happiness suffers in the absence of the structure and purpose their work provided.

Many of us find ourselves saying: “If only I didn’t have to work this 9-to-5, I would (fill in the blank (learn to paint, restore cars, travel, volunteer, practice yoga every day, learn to surf, etc., etc.)” And, unfortunately, some who achieve financial independence realize that it wasn’t their job holding them back from doing these things…it’s just that they aren’t truly motivated!

In other words, if you achieve FI and retire, it becomes time to “put up or shut up.” Happiness, psychology is showing us, is an elusive combination of mindfulness, exercise, purpose, authenticity, and social connection. The only real role money plays in happiness is that not having enough money to meet your needs will make you less happy. One you can confidently afford “comfortable” existence and have a little bit in the bank to feel secure, having more money will not significantly improve your happiness.

Consequently, let this be an opportunity to be honest with yourself: Are you chasing financial independence because you think it’s your ticket to happiness? If so, perhaps it’s time to step back from your hustle and instead focus on happiness in your daily life.

How to create your financial independence plan

So, we’ve gotten some common fallacies about financial independence out of the way.

Let me reiterate that I do not say any of these to discourage you from aspiring to financial independence, or from doing the work! Everyone should plan to achieve FI eventually – whether that’s at a “traditional” retirement age of at least 65, sooner, or much sooner. The “when” is up to you. The “how” is mostly the same. The “how” will just require some modification if you hope to retire young.

Determine your baseline annual expenses

If you’re already familiar with the theory of early retirement, you know that most places extoll annual spending as the most important variable in the financial independence equation.

The less you spend, the more you can save. The less you spend, the less you need to save to be able to meet your living needs with earnings from your investments. In other words, the less you spend, the faster you can achieve FI.

I do not disagree. All of this is true.

I merely want to underscore two things:

  • Minimizing expenses is only one piece of the puzzle.
  • Attempting to retire with too little can be dangerous.

Knowing this, it’s up to you to determine your realistic baseline spending. If you already live a modest but comfortable lifestyle that enables you to save at least 10% (better yet, 20% or more) of your income, then you can likely safely use your existing annual expenses as your baseline.

Perhaps, though, you’re already living a frugal lifestyle but still struggling to save. In this scenario, finding a way to earn more money (to enable a higher savings rate) is likely your only answer to get on the path to FI.

On the contrary, it’s possible that you plan to scale back your lifestyle after achieving FI. In other words, you’re spending more now than you intend to spend in retirement. Here’s where I urge you to be careful. Retirees get into trouble when they just assume they will spend less (we often hear 80% of pre-retirement spending) in retirement.

It’s very possible that the opposite will be true. Consider, for example, all the free time you’ll have after you stop working. What will you be doing? What hobbies or activities might you either undertake or dive into further and what might those cost? Will you travel? If so, consider the average annual amount you might spend on travel given that you might take larger trips (and spend more) in some years and travel less in others. Use an average.

Using the strategies and budgeting tools outlined earlier in Advanced Money School, arrive at a number that realistically represents what you think you will spend in your first year of “retirement.”

Determine your tax burden

It’s an absolute must not to overlook taxes when you plan for FI. Unlike when you’re an employee, nobody is going to be withholding taxes from your retirement income. You’ll need to estimate your tax liability (and make regularly scheduled payments) appropriately.

Now, here is an area where you really should consider professional advice of a certified public accountant (CPA). The tax code is immensely complicated and everyone’s situation is unique – especially when you start receiving a significant amount of income from a business, real estate, or investments.

Some early retirees living on frugal budgets manage to pay very little (or even) no federal income tax during retirement. Others with a large investment portfolio may have a significant tax bill each and every year as a result of dividends and other investment income.

Finally, remember that any appreciated investments you sell in a taxable investment account will be subject to capital gains taxes. Correctly estimating your annual tax liability (and minimizing it) can require some calculation.

When you have an estimate of your tax liability, you’ll want to add this to your estimated annual baseline expenses. This is the real amount of income you’ll need every year. Needless to say, if you plan FI around your expenses without taking taxes into account, your retirement plan is in big trouble!

Determine your target cash reserves

You know by now the importance of a cash emergency fund equal to at least six months’ living expenses. This rule, however, is designed for working people. Hopefully, a six-month emergency fund, when combined with unemployment benefits, could help most people ride out losing their job while they find another one.

If you’re going to retire and live on investment income, you’ll likely want to keep two years (or more) of living expenses in cash. Why so much? Consider it insulation from market volatility.

As I’m writing this, the stock market has fallen about 30% from its high due to the COVID-19 public health crisis and there have been huge fluctuations since depending on what’s going on in the news and the projections for what’s next with the pandemic. What’s important here is that if you’re retired, you really want to avoid the need to sell investments in such a down market. A large cash cushion – combined with a properly diversified portfolio – allows you to maintain your retirement lifestyle without making poorly-timed withdrawals in market crises.

The amount of cash to keep on hand is up to you. But here’s the catch. I don’t think you should count your cash reserves when calculating your annual withdrawal rate.

For example, if you determine you need $60,000 a year and plan to withdraw no more than 3% of your portfolio a year, your FI number is $2 million. Perpetual income scenarios like this one work only when you can earn an average annual rate of return that’s higher than the combination of your annual withdrawal rate and inflation.

In most scenarios, you need to earn at least 6% a year on average. An investment portfolio with enough equities can do this whereas a savings account cannot. While interest rates vary, the interest you’ll earn on cash will almost always be insignificant.

I realize you could make the argument that your cash reserves are just a lower-yielding part of your portfolio. As such, you can count it as long as the average annual return of the total portfolio is high enough.

Personally, I use this as an opportunity to be a tad conservative and further ensure the success of your FI plan. In the above example, if you wanted a 3-year cash reserve, you should actually save an additional $180,000 and your FI number would become $2.2 million.

Calculate income needs and sources “in retirement”

Next, consider all of your income sources except earnings from paper asset investments like stocks and bonds. Do you own a business that will continue to generate income? Will you work part-time? Do you own investment properties that will generate rent?

How long will these income sources last? If you expect them to last indefinitely, great. If not, you may want to consider planning your financial independence as if they didn’t really exist. In other words, you want to ensure your FI plan is viable based upon your investment income even if you’ll have earned income coming in for the first few years.

Before taking into account money you will need to withdraw from an investment portfolio, what percentage of your annual spending needs will this income cover?

The difference is the amount you’ll need to withdraw each year from your investments.

Determine your risk tolerance and withdrawal rate

If your goal is financial independence and you plan to “retire” – that is, draw any portion of your income from investment earnings as opposed to work – before your 60s, the amount of money you withdraw each year is paramount to the success of your plan.

As we discussed above, many sources cite the “4 percent rule” and say that you can live on your savings forever as long as:

  • Your savings are invested in a mix of bonds and at least 50% stocks and
  • You withdraw 4% the first year and then that dollar amount every subsequent year, adjusted for inflation

Remember, however, that this “rule” was designed for retirements up to 30 years. The younger you are, the more conservative you should be with your withdrawal strategy.

Again, I think a 3% strategy is better suited to younger retirees. If you can do it on 2.5% or even 2%, then you should really sleep soundly at night. Of course, getting to the withdrawal rate that you’re comfortable will require reducing your expenses, saving more, or both.

Risk tolerance & investment strategy

How you allocate your paper asset investment portfolio is the last piece of the FI puzzle.

The old-school rule-of-thumb for investors planning for a “traditional” retirement was to subtract your age from 100 to arrive at the percentage of bonds that should be in your portfolio. So, a 20-year-old would have a portfolio of 20% bonds and 80% stocks, and a 50-year-old would have a 50/50 allocation.

But investors planning for longer retirement timelines – either because they are retiring early or plan to live longer – will likely need to be more aggressive.

The Trinity Study was shown to work with portfolios consisting of at least 50% stocks. Success rates start to fall in portfolios with more than 50% bonds because the average annual rate of return is lower. Although the portfolio will be more stable in downturns, it cannot benefit from stocks’ strong growth in good years.

Young investors should strongly consider a mostly-stock portfolio. For investors in their 20s (and even 30s) who are not planning to retire anytime soon, a 100% stock portfolio could make sense.

Young retirees may want to remain aggressive with a portfolio that’s between 70% and 80% stocks.

Revisit Lesson 4 for a complete discussion of asset allocation.

Living in FI

There are few better feelings than looking at your financial statements and knowing that you can live on the earnings from your own assets whether you choose to keep working or not.

You’ll want to be prepared, however, for some things that may change when you actually begin living on your investment portfolio.

The shift to a scarcity mindset

Almost without exception, people who pursue FI or early retirement have been saving large percentages of their income for years. An effect of having an income that’s much higher than your expenses (all the while amassing a lot of savings) is a feeling of abundance. You earn more than you spend and you have a lot in the bank. This makes you feel, well, somewhat rich.

If you retire by quitting or reducing work, two things happen. First, you are no longer saving excess income. Second, you must begin withdrawing from your stockpiles.

Even if the markets are doing well and your principal continues to grow, these changes usually cause an abrupt 180-degree turn in mindset – from abundance to scarcity. Even though you trust your FI plan, you start to feel the limited nature of your resources. And this can happen whether you have a few hundred thousand in the bank or many, many millions.

If you’re naturally frugal, you might have trained yourself to live with a scarcity mindset even in times of abundance. And that’s good. It’s what you’ll need in retirement. For others, this change may take some getting used to. Periods of stock market turmoil that you never paid attention to before will be nerve-wracking. However resolute you have been in the past about sticking to your plan, you may find yourself questioning prior decisions about holding investments or how much to withdraw.

This is why I recommend a generous cash reserve and conservative calculations when planning FI. You want your FI plan to be built for worst-case scenarios. If it is, everyday ups and downs won’t rattle you. After all, a big part of financial independence is peace-of-mind. Your plan must be strong enough to provide an income. But it should also be strong enough to allow you to sleep well at night no matter what’s going on in the markets or the world.

Lesson 9 wrap up and conclusion

We will set (and hopefully reach) many financial goals in our lifetime. They might include saving our first $1,000, paying off student loans, buying a home, or building a $1 million 401(k). Along the way, we’ll achieve higher degrees of financial freedom and enjoy the flexibility it provides.

Meanwhile, financial independence remains the holy grail of financial milestones. Many people will never achieve it, meaning they’ll have no choice but to work into old age and need to rely on Social Security to live out a fairly meager retirement.

Those who work hard and make wise financial choices that balance enjoying money today while amassing wealth for a secure future will enjoy a lifetime of “enough.”

If you follow the advice provided in these lessons – as well as the fundamental financial protocols they’re built upon – you should enjoy ever-increasing levels of financial freedom and one day achieve FI.

Just don’t rush it.

I think young people’s focus on savings and FI is tremendous progress compared to prior generations who spent and spent without regard for tomorrow. But leaping into FI too early may backfire and put you behind-the-ball later in life.

The Financial Independence Worksheet is a spreadsheet that will help you calculate your FI date and projected retirement income. It also includes links to a few resources that will be helpful in projecting what early retirement might look like. Even if you’re years or decades away from FI, using this spreadsheet can be a powerful motivator for saving more – whether by spending less, earning more, or both. Use it as such. Use this advanced knowledge as you go about your life and make everyday financial decisions.

But, then, get back to work and to enjoying life now. Your money is valuable, but your time is invaluable. Make the most of it!