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We have already covered a lot of matter on the subject of Financial Independence (FI). However, we need to go into more details about the FI Number. This is an essential Personal Finance Metric. Your FI number is the amount of net worth you need to reach before you are financially independent. It is very important to know this number exactly if you want to know where you stand in your journey towards Financial Freedom. It sounds very simple. But it is not as simple as it looks.
If you want an accurate view of your FI number, you need to estimate how your expenses will be once you are financially independent. And you also need to consider your future income. There is also a second simpler strategy where you simply consider your current expenses. We are going to see all of that, and more!
In this post, we are going to cover in details on how to calculate your Financial Independence (FI) number.
Your FI Number
If you embark on a journey towards FInancial Independence, you need to know exactly what is your goal. And your goal is your FI number. This is a very important number. This is the amount of net worth you need to have accumulated before you can be financially independent.
We have already seen that there are several kinds of Financial Independence and Retire Early (FIRE). The kind of FIRE that you choose will impact your FI number. It will make it bigger (FatFIRE) or smaller (LeanFIRE).
So how can you calculate your FI number? First of all, you will need to take a look at your expenses. From it, you will be able to derive a first FI number. But you also need to look at your planned income to get your final FI number. So, let’s see how it goes.
Your expenses when financially free
Now, there are two strategies to compute your FI number based on your expenses. We will start with the most common strategy. For this, you will need to estimate the yearly expenses you will need when financially free. The other strategy will be covered in the next section.
The first thing you need to do is take a look at your expenses. You need to know how much you are going to spend in retirement. If you do not plan to retire, you still need to know how much you will spend once financially free. It is not an easy task.
Do not forget to take inflation into account when you calculate your expenses for the future. If you are planning to be FI in a few years, this will not change a lot. However, if you are planning in 20 years, this could make a huge difference. Obviously, inflation will highly depend on where you are planning to become financially free. Also, it is not enough to multiply your number by inflation. Some of the items in your expenses will not go up with inflation. For instance, inflation will not change your mortgage payments!
I have already talked in details about how to estimate your expenses in retirement. You need to take into accounts many things. For instance, your taxes will likely be less in retirement than they are now. And since you will have much more time on your hand, you also need to try to estimate how much you will spend during this time.
Your expenses now
The other strategy to compute your FI number is to only take into account your current yearly expenses. This is obviously easier. But it seems much less precise.
There is something really important with this strategy. You need to update your number at least once a year as you go. This will automatically take care of inflation and other lifestyle changes for you!
Moreover, if you plan to retire in a few years, your expenses will not change much! And since it is actually impossible to perfectly predict the expenses you will have at retirement, it is not such as a bad idea to lose some precision anyway. And it keeps it simple.
As long as you do not forget to update your FI number regularly, you can use your current level of expenses to figure out your FI number.
FI number from your expenses
Now that you have an estimation of your expenses, either from your current expenses or estimated for the future, you can get the base of your FI number.
But before this, you need to choose a Withdrawal Rate (WR). This is the percent of your net worth that you are allowed to withdraw each year. If you WR if 4% and your net worth one million, you will be allowed to withdraw 40’000 each year.
4% is the most common withdrawal rate. It comes from the original Trinity study. It showed that using such a WR had a 98% chance of being able to make the money last for 30 years. If you are more conservative, you can use a smaller WR. If you are more aggressive, you could even take a higher number. There are some people living with a WR of 5%. Personally, I use 3.5% as my withdrawal rate.
Once you have your withdrawal rate, you can get your initial FI number by multiplying your planned yearly expenses by 100/WR. For instance, if my planned expenses are 65’000 CHF and my withdrawal rate is 3.5%, my FI number is 1’857’142 CHF. That is almost two million CHF! That is how much I need to accumulate before I am financially independent.
So, what is your FI number at this stage?
There is a last component to the FI number that most people forget. It is the income that you may have when financially free.
Even after stopping working, you may have some income. For instance, you may have a rental property that brings some income every month. Or you may have a side hustle that you continue after retirement. You need to compute an estimate of how much you will earn per month, if anything, during your financial independence.
You should not consider dividends income towards your FI number! The reason is that they are already included in the withdrawal of your net worth every year. If you count towards FI number, you are more likely to run out of money before you are financially independent.
At some point, you are also likely to get some social security benefits for instance. However, this is difficult to calculate if you want to retire early. It is likely to change before you retire. And you still need to cover the years before official retirement age. Personally, I do not count for now my social security benefits in my retirement calculation. It is too early to do it. But if you are closer to retirement age, you may want to count it as an income as well.
Once you have an estimate of your FI income, you can compute your final FI number as the previous number minus income * 100/WR. For instance, if I could earn 1000 CHF per month in retirement, that would mean I could remove 342’857 CHF from my FI number. This would bring it down to 1.5 million. I do not plan to have this income, this was for the sake of the example. But many people do not realize that their FI number can be lower than they think if they get some income.
Refresh your number
One thing you need to remember is that this is not a science. Your FI number is likely to change over time. Indeed, your goals may change and your life may evolve more than you think now. It is very difficult to predict what you are going to spend in retirement. That is why you will have to refresh it from time to time.
If you are at the beginning of your journey, it is likely that it will take you ten years, or more, to become financially independent. Are you sure your FI number will the same in ten years? You may have new hobbies, new goals, new dreams or life may be much more (or less) expensive than it is now. That is why you should not set your FI number in stone.
I think that this exercise should be revisited at least once a year. Or even every quarter if you are motivated enough! You want this number to be as accurate as possible. If you think your FI number is too small because your expenses are increasing, it is better to realize that now than to be broke because you retired too early!
By now, you should understand that computing, or estimating, your Financial Independence (FI) number is something very important if you plan to ever get financially independent.
And computing this FI number is not as simple as it seems. The most accurate evaluation of this metric is based on the estimate of your expenses when you retire. However, there is no perfect way to estimate your expenses in the future. Therefore, a second, more simple strategy is simply to take only your current expenses into account for computing your FI number. If you refresh your number at least once every year, you will have a good evaluation of this number that will evolve over time, with you! With this, you should have a good idea of your goal of being financially independent.
Now that you know your FI number, you should go ahead and calculate your FI Ratio. These two metrics are directly related.
Have you ever computed your FI number? How do you calculate it? And what is it?