What is Financial Independence?
It’s one of those terms that sounds unambiguously good – of course we would want that! But what is Financial Independence? What does it actually mean? If we’re going to aim for something we should be precise in how it is defined.
Financial Independence typically means having the freedom to not work. It means that if you choose to work, you do so for reasons other than having to pay your bills or fund your lifestyle.
Why is Financial Independence a Goal Worth Having?
Most people are not, and will never be, financially independent.
This is not because it’s unachievable, but because it isn’t a goal they will set themselves. They lay wish for it, dream about it and hope that their other activities will somehow lead them to it, but they won’t think of it as a major goal towards which they should direct their energy and attention. They will spend the totality of their working lives working to keep the lights on. Their savings will not give them the freedom to choose to stop working at any time, because the loss of their salary would have a rapid and devastating impact on their lifestyle.
This is a massive source of stress.
Given how precarious our jobs are today, it’s not a very good idea to be in a situation where you can’t afford to be without one. Personally, I don’t know how I’d go about living under the constant threat of losing my job, if losing my job meant having to radically upend my entire life.Given how precarious our jobs are today, it's not a very good idea to be in a situation where you can't afford to be without one. Click To Tweet
Imagine the opposite situation.
You go to work every day, but you don’t have to. In fact, if you didn’t like your job you’d quit right there and then, because you don’t have to put up with a career you don’t like. You make decisions based on your own self-interest and not the best interests of the company, which means that both you and your employer set things up so that your best interests are aligned. If they weren’t, there would be no reason for you to work there.
You therefore, almost by definition, must enjoy your job and the people you work with.
Financial independence can also mean not having a job. It can mean choosing to travel the world while earning money doing tasks that are location-independent, such as freelance creative work or computer-based design or programming tasks, for example. It can mean not earning money at all, if that’s what you choose.
In short, financial independence gives you optionality, which in turn affords you the decision-making freedom to optimize your life in ways that aren’t available to others.
How Do I Know When I Have Achieved Financial Independence?
Setting targets is important, and there are simple and complex ways of deciding what’s enough to live off for the rest of your life.
Once you have that amount saved up, you’ve reached the goal, provided your cost of living doesn’t suddenly begin to increase.
That number is typically considered to be twenty-five times your annual expenditures.
So if it costs you £85,000 per year to live, you need to have £2.125 million saved and earning interest before you can stop working.
Why this number?
Because £2.125 million at 4% interest is £85,000 per year. If you have this amount invested, your investments should be growing faster than your living costs bring them down.
These numbers are all approximate – there are taxes involved, your cost of living won’t be the same before and after you quit your job and you won’t necessarily stop working, so you may still earn an income, but as a general rule, 25 times your annual costs is considered enough. That’s the finish line you set out to cross.
A More Detailed Approach
If you’re going to be spending time organizing your finances so that you can reach financial independence, then you’re going to be building, over time, the skills and knowledge to decide for yourself when you’re financially independent.
Until you get to that point and have made that analysis for yourself, you can use the 25X approach. Once you get to that point, you can consider insuring yourself against black swan events, modelling how much you’ll make from a job you really enjoy and how much additional travelling you may want to do with all the free time you now have.
The problems you have when you’ve got 25 times your annual expenses stored up are different to those you have when you’re anxiously anticipating the next paycheck.
If you’re like me, retirement is kind of a sad word. I associate it to people who have reached the point where they’ve finally, at the age of 60 or 65, earned the right to stop working and lay down their tools.
We need to change the way we think about that word. In fact, we need to change what it means entirely.
Retirement now means that we get to step away from a situation where we had no choice but to work, and we were maximizing our situation based upon that constraint. That meant that we couldn’t take certain risks with our career, couldn’t take more than 25 days off a year or 2 weeks off at once. We were responsible for things that didn’t bring us direct value because they belonged to someone else, who paid us to manage our little corner of their empire for them.
Retirement in the context of financial independence means that you get to choose what you invest your time in with a degree of freedom you didn’t have before. You get to design, build and live the adventure you choose. For some that might mean sangrias in the afternoon after a morning by the pool working on their novel. For others that might mean retraining as a doctor and volunteering to go to Somalia. The financially independent retiree is a free agent, living the life they choose.
How Do I Get There?
That’s the subject of this blog, and so there’s a lot to read, a lot to learn, a lot to absorb and a lot to do. It all boils down to setting money aside by earning more than you spend.
That said, here is a simple framework that everything else fits into:
Obviously, the first thing you look at is how much money comes in the door every day. The quickest and easiest way to earn more is often to get a better job, but the upside on that is limited for most of us. The side hustle is the millennial answer to the additional income question. To steal a concept from Nick Loper, it’s not what you do in your 9-to-5, it’s what you build in your 5-to-9.
We often learned to live within the means our day jobs afforded us. It’s much easier to see income from a side hustle as the bricks that will build our stairs to financial independence.
Equally obvious is how you spend your money. If setting money aside is the objective, you need to spend less of it today to maximize your savings. This site therefore contains a wealth of ideas for frugal living.
More useful to me were those ideas that allow you to adjust a non-frugal life incrementally, reducing your expenditures bit by bit. I couldn’t up-end our lifestyle for the sake of a project I had in mind, so “hacks” that didn’t necessarily impact our lifestyle were a good place to start building momentum on the savings front.
It’s important to consider that many of the people writing blogs in this area didn’t have a life partner when they started. Making radical changes to their lifestyle was something they could do without taking anyone else’s comfort into consideration.
Budgeting and Tracking
To do either of the above effectively you need to understand your own finances. To do that you need a system and a process. The system is your budget and the process is the tracking system you maintain on a daily basis, that tells you whether you’re on target.
This part is daunting for many but simple in reality. The hard part here is not building the budget or tracking your spending, but making sure that your day-to-day decision-making is informed by both. Otherwise it’s just an exercise in numbers.
Check out our guides on budgeting and tracking your expenditure.
Placing Your Money
The amounts that you save need to be put somewhere, and you need to make an informed decision early on as to where you’re going to put your money.
My choice is a low-free index tracker. This reflects the growth in the global economy (which is more or less relentless) and, despite occasional ups and downs, pays off over time. An important caveat here is that you must choose an index tracker that automatically reinvests any dividends. The magic of compounding is where the money is, not the growth in the value of the underlying stock.
If you find the stock market too daunting, you can start with savings in more traditional accounts. Bear in mind, however, that at the time of writing, the interest rates on these accounts didn’t even cover inflation. This means that even though the amount in the account increases over time, the rate at which prices increase across the board means that you’re still able to buy less and less with it as time passes.
Making The Decision and Planning For After
One day you’ll be able to make the decision to quit your job. You may not want to, but it will one day be an option that’s open to you.
When you make that decision, you need to already know what you’re going to do with your time afterwards. It’s not healthy to stop working without first finding a use for all the time that will free up.
I’ll file that one under good problems to have.