The Mechanics of Financial Freedom

Posted by Ronald Carter on October 16, 2016 in finance |

The concept of financial freedom is a pretty easy one to follow.

One of my favorite quotes on this topic comes from author Charles Farrell in his book “Your Money Ratios”:

All decisions you make should help move you from being a laborer to being a capitalist.  All of us are laborers.  But as a capitalist, you are not paid for the value of your labor, but for the use of your money.

In other words, you could think of financial freedom is being the point at which you transition from someone who needs to work for money to being someone who’s money works for them.  Rather than going to work every day and getting a paycheck, all of the money you’ll ever need will come from the assets you’ve spent your life accumulating.

So how does this work?  How exactly does one become a “capitalist”?

The Retirement Equation

This may shock you, but at its core, retirement planning really simple.  It really only comes down to three very important elements:

  1. How much income you desire each year when you’re retired.
  2. The withdrawal rate or percentage of your money that you can reliably take out of your nest egg savings each year.
  3. The size of the nest egg (the summation of all your savings for retirement).

Putting these three variables together, they relate to one another like this:

Or, if you’re interesting in understanding how much you need to save in your nest egg, then you can re-write the equation as follows:

These three factors are like a triangle.  They constrain one another.  You can’t move one part without affecting the other two.

Example

According to the Census Bureau, the estimated real median household income in the U.S. was $54,462 in 2015.  Because I like to use realistic numbers in my examples, we’re going to round this number down to $50,000 and use it as our target retirement income figure all throughout the book.

Of course, the equations are simple enough that you will be able to do the same thing with whatever number is better suited to fit your specific needs.

If we generically assumed we could withdraw 5% from our nest egg each year, then the target nest egg that we’d need to save up for would be:

$50,000 / 0.05 = $1,000,000

Is That All There Is To It?

Of course not!

[If it was, then this would be a very short book.]

The thing about retirement planning (and especially early retirement) is that it’s not the equation that’s hard, but the meaning behind the numbers that’s important!

I can’t stress this point enough, and so I’ll say it again.

Knowing what makes for “good” numbers is critical!

As we went through that simple example above, you probably had a lot of VERY good and completely valid questions:

  • Is $50,000 enough retirement income?
  • What if you need more?
  • What if you could be happy with less?
  • Is a withdrawal rate of 5% appropriate?
  • How long will it last?
  • Is it safe?
  • How do we know?
  • Where’s the data to prove it?
  • What sort of things do we have to invest in to make this all work?
  • What about inflation?
  • Is $1,000,000 a large enough nest egg?
  • What if you could enjoy the same amount of retirement income with a lower nest egg?
  • How much extra safety does saving more actually get me?
  • Is it even worth the extra trouble?
  • Will there be anything left to leave to my heirs?
  • … any many more!

That’s what the rest of this book is going to cover.  We’re going to explore each of these questions more thoroughly and really try to gain a better understanding of what numbers to use for each of these variables.

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