Most people do not like to work for money, and would rather like their money work for them. Then they can choose to take up work they like for the rest of their time. That is a powerful way to spend life, and is called being financially independent. No matter who the person is being in that life situation lets one to be out of the grind, and concentrate on things that matter the most. But it is not easy. That's why most people end up working for money all their life.
I have noted how it is possible for anyone to achieve financial independence within a reasonable period of time. I have also highlighted that increasing income is great; but lowering expenses is a much easier path for the average person. That means, increasing savings and investing over time should lead to the road desired. There is no question that savings are important. In fact, it is great to pay oneself first, and then spend what is available.
But savings rate concept is one hyped concept that many of those who have achieved or aspire to achieve the financial nirvana propagate. What they say is that as you increase your savings rate, the years to retire early reduce. While it is obviously true, there are limits to what you can say. Most of these people make reference to this, and go about making precise calculations on savings rate and years required to retire. That isn't always right.
Take a rather extreme instance, where they say if your savings rate is 100%, the years to retire is zero. Isn't there a limit? Suppose that your annual aftertax income is $100,000, and suppose you were sheltered and fed by some gracious soul for one full year. Now your annual savings rate is 100%. Great, but does that mean you can retire now? Note that being retired is used rather loosely; what it means is that you can choose to retire if you want to. With $100,000 in assets, can someone retire? Assumption inherent in this is, you find that gracious soul for your lifetime; remember your annual costs are zero. Yet, people accept it and talk about it.
Here are the assumptions behind the math on savings rate and years to retire.
I am not taking away the fact that savings are important; and the more you save, the easier and faster it becomes to be financially independent. Heck, that is way different from saying that if you save 64% a year, you can retire in 10.9 years.
I am also not taking away the basic assumption behind these calculations, which is that you require financial assets of about 25 times your annual expenses in order to retire well. This is again based upon the Trinity study, which says a 4% withdrawal is safe enough for a retirement portfolio to last.
Nevertheless, if we over simplify these basic assumptions, we will be doing it at our own peril. Consider this: With an annual income of $170,000 and savings rate of 90%, the calculations say that one can retire in 2.7 years.
Of course with the built-in assumptions, the portfolio increases to $494,000 within that period, which is roughly 25 times annual expenses of $17,000. Yet, one has to ask this question: are $17,000 sustainable annual expenses? What if someone, for the heck of it, started saving at 90% rate just to create a quicker and larger portfolio? The person might want to increase spending after the desired level of assets is built.
While there is no sure-fire way to calculate exact cash required to remain financially independent for life, my view is to remain as conservative as possible. One way is to assume zero real rate of return over the life period. Then the math becomes simpler: Your normalized, sustainable annual costs times the number of years required. For instance, if annual costs are say, $50,000 and expected number of years to remain financially independent is 30, then cash required is $1.5 m. For a 40-year time, cash is $2 m, and for 20 years, it is $1 m. That it is possible to earn some real rate of return is more comforting.
Let's make it more concrete. For someone aspiring to be financially independent at age 35 and expecting to live until 85, the timeline is 50 years. The required cash then is $1.25 m when annual costs are limited to $25,000 in today's dollars; and $2.50 m with costs of $50,000. It might appear to be daunting to make over $1 m by age 35, but there are ways to go towards it. I come back again to say that trying to increase income and reduce expenses over the years should help. There is no need to stick to the savings rate as such, as long as one chooses to vehemently save as much as possible.
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