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If you plan to retire early based on a withdrawal rate strategy, you base your FIRE plan on historical data. So, what would happen if the future is very different from the past?
We obviously cannot predict the future. So, what can we do? We can improve our FIRE plan with some margin of safety!
In this article, we will see several ways of adding some margin of safety into your FIRE planning.
The need for some margin of safety
If you plan your FIRE plan precisely for the parameters you know, you risk running out of money during your retirement. Here are three examples of things that could go wrong with your FIRE planning.
First, If you think you need your money to last 50 years of retirement, you could plan everything exactly for 50 years. However, what then would happen if you live longer than you planned? In theory, you could run out of money the day after your 50 years are finished.
Second, With Fire planning, you base your chances of success on historical data. Historically, the stock market has returned about 8% after inflation. If the stock market were to return only 6% on average after inflation, your effective chances of success would be significantly lower than what you planned for.
Third, when you do your FIRE plan, you base your planning on your planned expenses during retirement. But things can change in the future. For instance, you could suddenly have unexpected inflation in some part of your expenses. If your costs go up by 10%, your entire FIRE plan is at risk.
If you want to improve the chances of succeeding in these scenarios, you will need to add some margin of safety into your FIRE plan. Fortunately, there are many ways to achieve this.
However, there is a cost to adding some margin of safety to your plan. A safer plan means that it will be more challenging to reach your FIRE goal. You may have to work more years to accumulate enough money to become financially independent. So, it remains essential to keep a balance between not enough safety and too much safety.
Keep in mind that all these techniques are optional, and you would have to decide for yourself whether you want to include them in your FIRE plan.
Plan for higher expenses
The first way to add a margin of safety to your FIRE plan is to plan for higher expenses.
When you are computing your FIRE number, you use your yearly expenses as the base. So, your entire FIRE plan is only valid for these yearly expenses. Your FIRE plan only takes inflation into account, by default. So, if you increase your expenses by 10% because of a change of lifestyle, you are endangering your entire plan.
So, you have to be careful about estimating your expenses in retirement. It is more difficult than you think to know how much you are going to spend. And it is impossible to know it exactly. It is still an estimation.
So, a simple way to have a safer plan is to plan for higher expenses than your estimation. For instance, you could plan for 10% higher expenses. So, if you spend 10% more in retirement than what you planned for, your FIRE plan would still work.
But increasing your planned expenses means increasing your FI number accordingly. Adding 10% to your planned expenses is the same as adding 10% to your FI number. So, it will likely take you 10% longer to reach your goal.
It is up to each FIRE planner to decide how much percent they want to add to their planned expenses. Some people are comfortable with having no margin of safety there. Since we can only estimate our retirement expenses, it makes sense to increase this estimation to be safer. I will likely use 10% in my FIRE planning to be safer.
Don’t aim for a 100% FI ratio
In theory, as soon as your FI net worth reaches 100% of your FI number, you are financially independent, and you could retire.
But there is an issue with this approach: Sequences of returns risk. Indeed, not each FIRE starting point is equal. If you are 100% FI at the bottom of a bear market, you are in great shape. But if you are 100% FI at the top of a bull market, you will likely be in trouble once the bull market falls. Of course, we only know these two points in hindsight. But it shows that being 100% FI is not always enough and is market-dependent.
I see two ways of adding some margin of safety to this part of the plan:
- You could wait a set number of years after you are 100% FI before executing this plan. Doing so would give you an important buffer for the following years.
- You could wait until you more than 100% FI, for instance, 110% FI. A higher FI goal would greatly enhance the chances of success and reduce your susceptibility to sequences of returns risk.
I think that aiming for a higher percentage is what makes the most sense here. If you aim for 110% (or more or less, it is up to you!), you will significantly increase the safety of your FIRE plan.
Once again, you will also increase the time you need to reach your goal. For example, increasing your goal to 110% FI is the same as trying to reach 110% of your FI number. So, it will take you 10% longer to achieve that goal.
Aim for a larger success rate
When you choose your safe withdrawal rate, you are likely using the success rate as an essential metric to drive your choice.
The target success rate you choose will impact the Safe Withdrawal Rate (SWR) you choose and on your FIRE plan. For instance, planning for a 75% chance of success will likely yield a higher withdrawal rate than planning for a 95% chance of success.
So, if you increase your target success rate, you will also have a safer plan. For instance, if you were planing for a 90% success rate, you could target 95% instead.
It is difficult to quantify how much this will impact your journey to FIRE. Indeed, this will only change if you end up changing your SWR. Maybe increasing your target chance of success does not even change your SWR. But if it reduces your SWR by 0.1%, it will significantly increase your FI number and the time you need to reach it. But a lower withdrawal rate will also have a significant effect on the safety of your FIRE plan.
You can test this out with my FIRE calculator. For instance, with a 80/20 portfolio and 50 years of retirement, you need the following withdrawal rate:
- 4% to get a 85% chance of success
- 3.8% to get 90% chance of success
- 3.65% to get 95% chance of success
- 3.2% to get 100% chance of success
So, you will find your withdrawal rate based on your target success rate. And as you can see, this can make a significant difference in your withdrawal rate. But this could make a very large difference as well in the chance of success of your FIRE plan.
Choose a lower withdrawal rate
Finally, a powerful way to add some margin of safety to your expenses is to choose a lower withdrawal rate.
A lower withdrawal rate means you are going to withdraw (and spend) less money every year. As such, your chances of success will significantly increase. For instance, if you were planning for a 3.75% withdrawal, you could plan for 3.6% instead. A lower withdrawal rate would strongly impact your chances of success.
However, It also means you will need to allocate more money for your retirement. Therefore, a lower withdrawal rate means a higher FI number and a longer time accumulating this money.
For instance, with yearly expenses of 100’000 CHF, you will get the following FI numbers:
- 2’500’000 CHF with a 4% withdrawal rate
- 2’666’666 CHF with a 3.75% withdrawal rate
- 2’857’142 CHF with a 3.5% withdrawal rate
So, we can see that the impact of a lower withdrawal rate on your FI number is very significant. So, using a 2% withdrawal just because you want to make sure you can retire does not make sense if a 3.25% would already guarantee success.
There are several ways you can use to add some margin of safety to your FIRE plan. They can help significantly in increasing the safety of the plan.
However, more margin of safety does not come free either. Increasing your FI number by 10% means you need 10% more money. So, it will likely take you 10% longer to reach that goal.
So, you need to find a balance of good safety. If you have too much, you will end up with a lot of money at the end of your retirement period. This may be good if you intend to leave a lot of money to your heirs. But it also means that you could have retired earlier.
Personally, I think I am going to apply a total 10% margin of safety on my FIRE plan. But of course, I will not be financially independent for at least 15 years. So, I will have time to review my FIRE plan for many years. Things may change in the meantime.
I believe that adding some margin of safety to your FIRE plan is important. But adding too much will hinder your chances of reaching your FIRE goal. Make sure to not go overboard!
There are other ways you can help your chances of success. For instance, you could be prepared to get some extra income one way or another should the stock market dip too much. Or you should be able to reduce your expenses somehow in case of a bear market. But these are more reactive measures rather than margin of safety planning.
What about you? How do you add some margin of safety to your FIRE plan?