Financial independence; the ability to live life without ever needing to work for money again as you have enough wealth built up to keep you going. But how much do you need and how do can you work it out?
The very first thing to realise is that for each and every person there is a particular number in terms of money where the amount is enough to last them for the rest of their lives. The number will be different for everyone based on various factors such as where they live, their families, responsibilities in life, lifestyles and many other things. But a number can be reasonably calculated based on the typical things that a person does on a regular basis over a long period of time.
Naturally, if you pick a really large number such as £1 billion then that’ll be enough for any person. Even the biggest spenders in the world can’t really complain; they might be able to spend it all but they can’t go around saying it wasn’t enough to last them the rest of their lives.
It’s not just the typical socialite you need to rely on either, even you or I could think up all sorts of crazy things that you could do with a billion in order to spend it all; buy a super yacht, a private jet, fleet of super cars, stay in the nicest hotels and eat the best foods around the world. Keep spending on luxurious items and pastimes and eventually the money will dry up.
But most, if not all, of those things aren’t needed if you’re thinking about making the money last for the rest of your life, and so while it’s possible to spend all of the money it doesn’t mean it wasn’t enough in the first place.
So let’s break down what a billion really means for a single person. Let’s imagine that a person lives until 100 years old, that would be higher than the average lifespan in the world but with vast riches it’s not hard to imagine they have a better chance of reaching triple digits, and they spend an equal portion of their money every single day without fail. They would need to spend just over £27,379 every day of their lives from 0 to 100 years old in order to get through all the money. Here’s the maths:
£1,000,000,000 ÷ (100 years × 365 days + 24 leap days) = £27,379.26
It’s a bit like them putting down a house deposit every single day of their lives, and it would take 100 years for their money to run out. If you think about it, even after doing that for 99 years and 364 days they’d probably still have more spare cash than the majority of people in the country.
It’s an extreme example, but the point is that the number is clearly much, much more than what any individual really needs in a lifetime. Simply picking a large number doesn't work; it'll most likely be enough but it's also likely to be much more than what you really need.
Multiply what you spend in a year
So would a better way be to calculate what you need in a year, and then multiply that out to the end of your life?
Let's give it a try.
In this approach you need to know how many years you think the money will need to last and then you need to figure out how much you typically spend in a month. You can go down to the individual day as I did with the £1 billion example, but I personally find it is easier to work this out on a monthly basis. It gives a bit more flexibility as some days you might spend more than others.
Imagine if you were 25 years old and each month had a spend of £1,000; that covers all the things like living costs, food, activities and hobbies, bills and maybe some insurance. Over the course of a year the spend will add up to £12,000.
If you expect to live until you are 80 years old then you would need to have £660,000 to last you throughout your life. Here’s a diagram to show my workings:
If you expect to reach 100 years old then you would need £900,000, as you would need to spend £12,000 a year for another 20 years. You can also see the workings for that in the diagram.
Keep in mind that these calculations don’t take into account the effects of inflation which means that as time passes things will become more expensive to buy. And it also assumes that absolutely nothing in terms of spending habits or circumstances will ever change.
But at least there was some logic and maths involved which makes it a better guess than simply picking a big number. We'll call this a more accurate estimate but is there still another method that means even less money is needed?
£660,000 is still a lot of money to save up after all.
Invest and withdraw
So far, we have only looked at money as a static number like it's just a pile of cash to be chipped away at over time. As long as that pile is big enough then it will last a lifetime. But that's incredibly ineffective and makes building wealth a far more difficult task than it really needs to be.
What you want, or need, is money that will grow and provide some sort of return so that anything you spend will automatically be replaced over time.
Imagine you could magically receive £1,000 a month without needing to do anything. You'd be able to live off that money as long as you don't over spend it. Sound good?
Totally possible and requires less money than the sums we've worked with so far.
The method to get your money to grow over time is by investing it into something that will provide a return. There are a wide range of different options but the one I'm going to stick with in this example is the financial stock market. By investing into a globally diversified portfolio you can reasonably expect a return of around 7% each year on your money on average. So for each £100 you invest, after a year you will receive £7 on top of what you invested without needing to do anything.
With this in mind you can then try to calculate how much you would need to have invested, and how much you can safely withdraw each year in order to provide yourself with £12,000 and still have enough money to last you a lifetime.
Since your money is growing at a rate of 7% each year on average, does that mean you could withdraw 7% of your investment each year and that will make your money last a lifetime while allowing you to keep spending the same amount each year?
Here's why it will not work mathematically:
£171,157.20 is less than the starting investment value, therefore the next time you withdraw 7% you will effectively have less money to spend. This means the withdrawal rate cannot be maintained and may not be able to reliably support you for a lifetime.
As a side note, the figure of £172,000 is what I calculated to the nearest thousand in order to be able to get £12,000 from withdrawing 7%.
Even if you change the above calculation so that the investment value grows by 7% before you withdraw anything, the results will be the same in that the investment value trends downwards. So you need to withdraw a lower % rate.
Mathematically a withdrawal of 6% when the investment growth is 7% would mean the money could last forever, but in reality you want a slightly bigger margin of error to account for the times where your investments are not growing as much as they do on average.
A generally more accepted rate is something between 3% and 4%; let's work with 4% and see how that works out over time.
In order to calculate what you need to have invested to be able to withdraw £12,000 as 4% of your investments you simply multiply by the number needed to make 4% into 100% and that would be 25. Here's the maths:
Calculate how many 4% are in 100%: 25
(100% ÷ 4%)
Multiply £12,000 by 25: £300,000
(£12,000 × 25)
Verify by calculating 4%: £12,000
(£300,000 ÷ 100) × 4
So the total invested amount to be able to withdraw £12,000 at 4% is £300,000. Let's now repeat the earlier withdrawal calculation to see what happens after a year when withdrawing 4% from a £300,000 investment portfolio. Here's the diagram:
£308,160 is more than the starting value meaning the next time you withdraw 4% it will be enough to cover your £12,000 of yearly spending.
You'll actually have £12,326.40 (4% of £308,160) to spend meaning there's £326.40 extra in your pocket that you could do whatever you wanted with.
So there you have it; by investing your money into a globally diversified portfolio that grows on average at 7% each year, and by withdrawing a small amount from your investments that is lower than the amount it is growing by, you are able to keep spending that money without actually losing any wealth.
And due to that, provided you know what you are actually spending each month or each year, you can more confidently calculate what total sum you need in order to have money that lasts you for a lifetime.
£300,000 isn't a small amount of money but it is less than half the amount of £660,000 that would have been needed in the "Multiply what you spend in a year" approach.
You also don't need to work for that money after you've invested it. Yes, you need to make £300,000 in the first place but after that point you can just let your money grow by itself. That's way better than needing to grind out the entire £660,000.
And if you're smart with your withdrawal rate by keeping it reasonably lower than your investment growth each year, your wealth will not be eroded away by inflation and may in fact increase over time. One day you might even surpass the £660,000 despite never lifting a single finger again to earn money.
Is it really that simple?
So is it enough to just build your money to a certain level, invest it, and take 4% each year?
Basically, sort of… but also, not entirely. You need to build that money up in the first place (which I will cover in later articles) and once you've reached the number you still need to manage your wealth sensibly to ensure it lasts.
There are many pitfalls and life events that can temporarily put you off course on your financial independence journey such as your investments losing value, or your investments grow less than the average 7% annually for an extended period of time. In these situations you need to adapt your withdrawal and maybe find ways to supplement your income.
There might even be things outside of your investments that have a somewhat adverse effect such as an unexpected expense that pushes your spending above what you budgeted for, meaning you need to withdraw more than 4% in a year.
So it’s not quite that simple but the key point here is that there is a mathematical way that allows you to figure out what you need in terms of money for the life you live (or want to live) and you can use that knowledge to build a good solid foundation for your financial wealth and ultimately plot a path towards reaching financial independence.
I don't know about you but I think that's way better than simply stating a big number and not having a real understanding on how or why it works.