For the first time, I have computed my Financial Independence (FI) ratio. In this post, I am going to explain to you what is FI and how to compute your FI ratio.
First, what is Financial Independence (FI)?
It is 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.
Withdrawal Rate and FI Ratio
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, 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 and my SWR is 3.5%.
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. You should use the amount of expenses you plan for FI. So, your target net worth is 100/SWR times your planned annual expenses.
Finally, how do I get my FI ratio?
You now have your target net worth. That is the net worth at which you will reach Financial Independence. You FI ratio is simply your current net worth divided by your target net worth. If you have a target of 1 million and you have 100’000, your FI ratio is 10%.
If you need, you can see how I calculate my net worth.
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||57’571 CHF|
|Target Net Worth||1’612’015 CHF|
|Current Net Worth||54’583 CHF|
|Missing Net Worth||1’557’431 CHF|
|Yearly income||71’400 CHF|
|Running Savings Rate||14.60%|
|Yearly savings||10’424 CHF|
|Time to FI (w/o returns)||149.39 years|
|Time to FI (w/ returns)||38.83 years|
I have computed my expenses over the last 12 months (not counting March). This gives me about 1.6 million CHF to save. Given my current Net Worth, I am missing about 1.55 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 3.5%.
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 39 years until I reach FI. This is not great since I will already be past the retirement age in 39 years. Not considering any return on the investment portfolio, it will take me 149 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, my current savings rate is higher than 14.6% and I am still working on increasing it. 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.
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.
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 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.
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?