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When you have a goal, it is always good to know your progress towards this goal. If you are trying to become Financially Independent, it will be essential for you to know how far away you are from your goal! For this, you will need to know your Financial Independence (FI) Ratio. This ratio will tell you how close or how far you are from reaching your goal.
If your goal is to become FI, you will have a certain amount of net worth that you will have to reach before you can become FI. This amount of net worth is your FI number. Once your net worth equals your FI Number, you are financially free. That is the main idea.
Your FI ratio will tell you exactly where you are on your path to Financial Independence. In this post, we are going to see precisely how to compute your net worth goal. And then, how to calculate your progress towards your goal. It will help you a lot to know if you need to adjust your strategy to reach your goal on time.
Stay tuned if you want to know when you are going to be financially free!
First, what is Financial Independence (FI)?
Financial Independence means you do not need to work to sustain your lifestyle. It is also sometimes called Financial Freedom. You are financially independent when you have enough money to maintain your lifestyle without working.
For this, your wealth must generate income. And this income must be higher than your expenses. The primary way to generate income from your net worth is to withdraw from it. However, you need to withdraw little enough to sustain your wealth for the longest time. Otherwise, you will end up with no money.
It is only one of the ways to reach Financial Independence. But this is the most standard way. Some people prefer to focus on passive income. And some people focus entirely on real estate to become financially independent.
There are many reasons to become Financially Independent. It is currently very popular on the internet. Especially with the Financial Independence and Retire Early (FIRE) philosophy. The idea is to become Financially Independent as soon as possible and retire early. But you can also be Financially Independent and not retire. You can then choose to do precisely what you want with your life since it does not depend on your career income anymore.
First, we will assume you are following the withdrawing idea of Financial Independence. But I will also talk about the FI ratio in the concept of entirely passive income.
Your Withdrawal Rate
If you want to become financially independent by having a large enough net worth to sustain your expenses, you may have heard of the 4% rule. It states that if you only withdraw 4% of your investment portfolio every year, it should sustain you for at least 30 years. This percentage is your Withdrawal Rate (WR) or Safe Withdrawal Rate (SWR).
These rules assume that you invest your portfolio in the stock market. Generally, the 4% rule assumes 75% stocks and 25% bonds. But the asset allocation is up to you. 4% is the recommended SWR. But some people choose to be more conservative (<4%) or more aggressive (>4%). I am more conservative, so my SWR is 3.5%.
You need to keep in mind that the original 4% rule is based on 30 years of retirement. If you retire very early and plan for 50 years of retirement, it may not work in the same way. For this, you may have to reduce your SWR. You can take a look at my retirement calculator to help you.
To learn more about Withdrawal Rates and the 4% Rule, you should read about the Trinty Study Results!
Your Financial Independence Number
Now I got my SWR, how much do I need to be FI?
It is pretty straightforward. By dividing 100 by your SWR, you will have the number of years of expense you should save. For instance, for my SWR of 3.6%, I have to accumulate 27 years of my annual costs.
If you think your expenses are going to go up or down in the future, you should also account for that. Indeed, you should use the number of expenses you plan for FI. However, this is difficult to estimate. If your retirement is in a long time, you may take your current annual costs as a good estimation. It is what I am doing. Every year, I am updating my FI Number to reflect our current situation.
So, your target net worth (your FI number) is 100/SWR times your planned annual expenses. If you have yearly spending of 100’000 USD and SWR of 4%, you need to accumulate 2.5 million dollars to become Financially independent. If you spend 50’000 USD per year and plan to withdraw 3.5% every year, you will need to accumulate 1.4 million dollars.
This target net worth is also called the Financial Independence Number or FI Number. I wrote an entire article to help you calculate your FI Number.
Your FI Ratio
Finally, how do I get my FI ratio?
You now have your target net worth or your FI number. That is the net worth at which you will reach Financial Independence. As soon as your net worth is higher than this number, you are financially independent!
For this, you will need to know your current net worth. As an example, you can see how I calculate my net worth. Your net worth is the value of all your assets minus the value of your liabilities (debts). But you need to be careful about some assets that can depreciate or are difficult to sell.
Your FI ratio is simply your current net worth divided by your target net worth. It could not be simpler!
If you have a target of 1 million CHF and you have 100’000 CHF, your FI ratio is 10%. Or if you have a target net worth of 1.4 million USD and have 200’0000 USD, your FI ratio is 14.28%.
As soon as your FI Ratio reaches 100%, you are financially free!
My Financial Independence Ratio
As an example, let’s see how my situation is at the current time. I have calculated the results for my goal. I’ve also calculated how many years it will take me to get there at the current pace. Here are my results:
|Expected Annual Return||5.0%|
|Years of expense||27|
|Running expenses||64’781 CHF|
|Monthly expenses||5’398 CHF|
|Target Net Worth||1’749’090 CHF|
|Current Net Worth||230’138 CHF|
|Missing Net Worth||1’518’952 CHF|
|Yearly income||130’200 CHF|
|Running Savings Rate||50.56%|
|Yearly savings||65,830 CHF|
|Months to FI||166|
|Years to FI||13.75|
|Date to FI||2033-10-18|
|Current Withdrawal Rate||28.14%|
|Months of FI||42.63|
|Years of FI||3.5|
I have computed my expenses over the last 12 months (not counting this month). It gives me about 1.75 million CHF to save. Given my current Net Worth, I am missing about 1.5 million CHF. If you compute the ratio of your net worth and the target net worth, it gives you your FI ratio. Mine is a meager 15.15%.
You can also calculate an estimate of how many years you need to save this amount. I have computed my savings rate as the average of these twelve months. I am assuming a 5% annual rate of return, which is conservative. It gives me almost 14 years until I reach FI.
This result is not so bad since this will be before I am 50. And my primary goal is to become Financial Independent before I am 50. It seems I am on track to reach my goal!
Improvements for the calculation
My calculations are not entirely correct. First, I am still working on increasing our savings rate. My current income is also higher than it was on most of the twelve last months. Finally, I am also working on improving my expenses. The last twelve months include some pretty bad months.
Another important thing is that your expenses in retirement will likely be different from now. For instance, you will pay fewer taxes in retirement than what you pay now. But it is quite likely that your health expenses will go up. It is challenging to compute the costs you will have to pay in retirement.
There is another thing that we have not taken into account. The second pillar and the third pillar can only be taken out at the retirement age. For now, I include them in my net worth. But this money will only be used once I reach the official retirement age.
Also, the first pillar will give you a retirement pension. If you want a really accurate calculation, you will have to integrate many more factors. It means that from retirement age, some of your expenses will be covered by the first pillar. It would be the same in the United States with social security.
Improving your FI Ratio
Of course, now that you have this metric, it is essential to learn how to improve it. You may want to become financially free faster than the current predictions.
Of course, you can increase your net worth to increase your FI ratio. But it is not trivial to improve it. And this is not something that will happen in one day unless you play into the terrible odds of the lottery.
The first thing you should do to improve your FI ratio is reducing your FI Number. For this, you have to lower your expenses. All your yearly costs get multiplied by 100/SWR. If you plan on using the 4%, all your expenses are multiplied by 25. If you can cut your costs by 1000 USD per year, this is 25’000 USD that you do not need to save!
The second thing you can do to speed up your FI ratio is improving your income. Increasing your income will not directly increase it. But it will grow faster over the years. Of course, this is only true if you do increase your expenses. Do not fall into the trap of Lifestyle Creep.
Another thing you can do to increase your FI Ratio is to use a larger SWR. Now, this is dangerous. The higher your SWR is, the more risks you deplete your net worth in case of a large downturn. But this would decrease your FI number significantly and hence increase your FI ratio. I would not do that unless I was aware of the risks.
Finally, by increasing your returns on your capital, you will also be able to speed up your FI Ratio. To increase your profits, you generally can take on more risks. Once again, this is dangerous. And it is not easy to get a guaranteed return on income. But this would significantly increase the speed at which your net worth increases.
If you follow some of these ways, you will become Financial Independence faster!
Keep in mind that all these numbers are only estimates. Your expenses could go up. Your salary could change. The stock market could crash. Your Financial Independence ratio and the estimated number of years left are useful numbers. But they are not definite.
For instance, I plan to have kids, this will increase my expenses. And my income will probably increase by the time I retire. It should not prevent you from calculating your FI ratio. You should just update your FI number at least once a year instead of using a fixed amount for too long.
Another thing you should keep in mind is that the SWR rule has been created for the US market. You may have to adapt it to your country. And, if you plan to retire early (in your thirties, for instance), this rule will not cover you long enough. So take everything like this with a grain of salt. Every situation is different.
If you want to read more (much more) about SWR, you can read the Ultimate Guide to SWR, by Early Retirement Now. It is excellent.
Is 100% FI Ratio enough?
By definition, when your FI Ratio reaches 100%, you are Financially Independent. In theory, this means you can quit your job.
In practice, you have to be careful about being exactly at 100% FI Ratio.
First, if you retire from your job, you will have a ton of time in your hands. And filling your time may cost you money. You may visit more museums for instance. Or you may travel more. It is difficult to estimate how much you are going to spend in retirement.
Secondly, you will have no margin of safety. This means that if something bad would happen and cost you a lot of money, it could be bad. I am not talking about small emergencies but large ones. Small emergencies should be covered by your emergency fund.
Finally, at 100%, you are still subject to bad timing. If you retire at the peak of a bull market with a 100% FI Ratio, you are in a risky situation. The market may crash 40% the year after. And your portfolio is unlikely to recover from that. On the other hand, a 100% FI Ratio at the bottom of a bear market would be much better.
Since we cannot time the market, it is better to get some margin of safety with our FI Ratio. The exact goal would probably depend on people’s risk tolerance. For me, 110% would probably be fine.
The Passive FI Ratio
Now, what we have seen is the definition of Financial Independence that I use. But there is another definition of the FI Ratio used by some people.
Some people do not want to withdraw from their principal in retirement. That means they will focus on passive income. It can be an income from their principal, such as dividends or interests from a bank account. Some people focus, especially on P2P Lending. You can also include social security or other retirement benefits into your passive income.
For some people, this can also be income from a blog. However, that last one is not passive (contrary to what some people would like you to think)! But it sure can help you retire.
For these people, we can compute a Passive FI Ratio. It is simply the ratio between your passive income and your current annual expenses. For instance, if you have a passive income of 10’000 CHF and yearly expenses of 40’000 CHF, your current Passive FI Ratio is 25%.
I do not focus much on passive income. But I think this ratio is quite interesting. It is not necessary to aim for a Passive FI Ratio of 100%. Both ratios can play together. If you have a Passive FI Ratio of about 50%, this can reduce your FI Number consequently since you will need a smaller net worth. If you can get a guaranteed income of 1000 CHF per month in retirement, this will significantly reduce your yearly expenses!
For instance, one of the bloggers using this definition of Passive FI Ratio is Joe Udo at retireby40. He focuses a lot on his passive income.
Your Financial Independence (FI) Ratio will tell you exactly where you are on your road to FI. It is a straightforward metric that can help you track your progress. It is a great metric that should probably be part of your financial metrics. But there are plenty of other personal finance metrics.
Even though it may not be vital, it is an interesting metric to follow. It will give you an overall idea of where you are in your quest for financial independence. If you graph it against time, you will also see if you are going faster over time or not.
In the future, I am going to try to follow the evolution of my FI Ratio. But for now, I will not pay too much attention to it. I will focus on decreasing my expenses and increasing my savings rate. I am not worried about the rather large number of estimated years before retirement. Indeed, I am just getting started with my budget overhaul. And I know I can reduce my spending and increase my income. It will help me reach FI faster.
If you liked this FI Ratio Metric, read about More Personal Finance Metrics.
By the way, you do not have to do the math yourself, you can use my Retirement Calculator.
What is your Financial Independence (FI) Ratio? What do you think of this metric?