If you are trying to become Financially Independent, it will be interesting for you to know your Financial Independence ratio. This ratio will tell you how close, or how far, you are from reaching your goal.
First, what is Financial Independence (FI)?
You are financially independent when you have enough money to sustain your lifestyle without working. For this, your wealth must generate income. And this income must be greater than your expenses. The main way to generate income from your wealth is simply to withdraw from it. However, you need to withdraw little enough to sustain your wealth for the longest time. This is only one of the ways to reach Financial Independence. This is the most used 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 exactly what you want with your life since it does not depend on your career income anymore.
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 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 a bit more conservative, my SWR is 3.5%.
Your Financial Independence Number
Now I got my SWR, how much do I need to be FI?
In fact, it is pretty easy. By dividing 100 by your SWR, you will have the number of years of expense you should save. For instance, for my SWR of 3.5%, I have to accumulate 28 years of my annual expenses. 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 amount 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 expenses as a good estimation. So, your target net worth is 100/SWR times your planned annual expenses.
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!
Your FI ratio is simply your current net worth divided by your target net worth. If you have a target of 1 million CHF and you have 100’000 CHF, your FI ratio is 10%.
If you need, you can see how I calculate my net worth. Basically, this is the value of all your assets together. But you need to be careful about some assets that can depreciate or are difficult to sell.
My Financial Independence Ratio
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:
|Years of expense||28|
|Running expenses||68,052.91 CHF|
|Monthly expenses||5,671.07 CHF|
|Target Net Worth||1,905,481.48 CHF|
|Current Net Worth||170,998.72 CHF|
|Missing Net Worth||1,734,482.76 CHF|
|Yearly income||112,200.00 CHF|
|Running Savings Rate||45.886181%|
|Yearly savings||51,484.29 CHF|
|Months to FI||215|
|Years to FI||17.916667|
|Date to FI||2037-04-05|
|Current Withdrawal Rate||39.797321%|
|Months of FI||30.152814|
|Years of FI||2.512732|
I have computed my expenses over the last 12 months (not counting this month). This gives me about 1.9 million CHF to save. Given my current Net Worth, I am missing about 1.73 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 9.85%.
You can also calculate an estimate of how many years you need to save this amount. I have calculated my savings rate as the average of these twelve months. I am making the assumption of a 5% annual rate of return, which is conservative. This gives me almost 18 years until I reach FI. This is not so bad since this will be before I am 50. Not considering any return on the investment portfolio, it will take me 150 years to reach my goal. I will be long dead! The difference between these two numbers shows the power of compounding!
My calculations are not entirely correct. First, my second pillar and my life insurance are not taken into account in my net worth yet. I will update my net worth this year to start including it. Then, 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 thing that is important is that your expenses in retirement will likely be different than 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 difficult to compute correctly the expenses you will have to pay in retirement.
There is another thing that is not taken into account. The second pillar and the third pillar can only be taken out at the retirement age. And also that the first pillar will give you a retirement pension. If you want a really accurate calculation, you will have to integrate many more factors.
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 definitely increase my expenses. I will also change jobs in June, increasing my income. This should not prevent you to calculate your FI ratio. You should just update your FI number at least once a year instead of using a fixed number 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 really 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 really good.
The Passive FI Ratio
Now, this the definition of the Financial Independence that I personally 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. This can be income from their principal such as dividends or interests from a bank account. For some people, this can also be income from a blog. However, that last one is not really passive!
For these people, we can compute a Passive FI Ratio. This 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 annual 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%. In fact, 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.
For instance, of the bloggers using this definition of Passive FI Ratio is Joe Udo at retireby40. He focuses a lot on his passive income.
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 really 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. This will help me reach FI faster.
Even though it may not be extremely important, 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.
To learn more about Financial Independence (FI) metrics, you can spend some time reading about your FI number.
By the way, you do not have to do the math yourselves, there are plenty of Financial Independence calculators online, like this one.
What do you think of my results? Did you ever compute your FI Ratio?