Most of you are reading this right now because you want that elusive “financial freedom”. This usually revolves around net worth, and many of us (ahem) have a specific net worth goal they want to achieve. Various formulas and calculators abound. The popular book The Millionaire Next Door suggests this formula for a target net worth:
In addition, there are various debates on how to measure net worth. Do you include your primary residence, or not? What about cars or jewelry? How do you properly account for pre-tax accounts? However, while reading this post at Early Retirement Extreme amongst others I realized that these are not the things I need to be focused upon.
Financial Freedom Ratio
If someone tells you that they have a net worth of $1,000,000, you might be impressed. But what if they spent $150,000 per year? If they stopped working, the money wouldn’t last very long. However, if they only spent $15,000 per year, they might already be set for life. In other words, your income doesn’t matter. Your expenses do. It may be assumed that the two are related, but that is not necessarily true. We all have the power to disconnect the two.
I’m sure somebody somewhere has already coined this term, but until told otherwise I will call it the Financial Freedom Ratio (FFR):
By liquid, I simply mean you can sell it for cash while not affecting your expenses. (Don’t count your car if you need it for work.) For example, if you had $200,000 but only spent $20,000 per year you would have the FFR value of 10 as someone with $1,000,000 but spent $100,000 per year. This also calls into focus how important spending patterns are when talking about financial freedom. Let’s say you had the 200,000 net worth and you wanted to increase your FFR from 10 to 11. You could either
- increase your liquid net worth by $20,000 and spend the same,
- decrease your annual spending by $1,820 and not earn any more money,
- or some combination of spending less and accumulating more.
Sure, it can be very difficult to keep slashing expenses, but this ratio keeps you honest as to how close you are to financial independence.
What Is A Good Financial Freedom Ratio?
To find this, I went to the Vanguard Annuity website and looked up a price quote for their inflation-adjusted fixed immediate annuity (Lifetime income option, fixed payment, bottom right). This means that, if I give Vanguard a lump sum of money, they will give me a regular income that is adjusted every year for inflation per the CPI-U. (Annuities are subject to the claims-paying ability of the issuing insurance company, which is AIG Insurance.)
I input that I was 30 years old and wanted an inflation-adjusted $30,000 a year ($2,500 a month) for the rest of my life. The quote was $857,000. So a lifetime of my required income requires an FFR of 28.6 ($857,000/$30,000). As you get older, the number decreases.
Using the popular but controversial 4% safe-withdrawal-rate rule for a balanced stock/bond portfolio, you would need a FFR of 25 to have a good chance of living off of your investments without having to annuitize. Keep in mind the 4% value is not adjusted for inflation, so your buying power would decrease each year.
What’s My FFR?
I’m not sure exactly how much I spend per year. I need to fix this. I should be able to back out the numbers for 2007 pretty easily since I track our net worth and I just did my taxes, but I’d need to cancel out things like unrealized investment gains. Roughly, I would say that last year we spent somewhere between $25,000 to $30,000. This year, it will be much higher due to housing expenses, although one day the house will be paid off. My FFR is certainly less than 10 right now, more like in the 8 range. Single-digits!
Track Your Expenses
I like the FFR because it gives me a better idea of how close we really are to financial freedom. In addition, it reminds me that our expenses matter equally as much as our net worth. Do you know how much you spent last year? I am convinced that spending is a habit. If you spend modestly now, it will be easy to maintain this in the future. If you spend lavishly now, it will be very difficult to downgrade later on. We all have our luxuries which we hold dear, I know I certainly do, but it has to be weighed against how long you want to keep working and saving.
So, after all this I suppose I need to figure out how to gradually shift to a simpler and less costly lifestyle. Heck, forget cutting expenses, I spend a lot of effort simply trying not to accumulate more expenses these days…