Financial Independence Isn't A Dollar Amount Or An Equation

I’ve already spilled a lot of ink talking about financial independence, but I never bothered to define it.

I suppose this should have been post No. 1 on this blog, but it wasn’t top of mind when I was in original creative mode.

Full disclosure, my inspiration here is a recent post by The Physician Philosopher in which he defines financial independence by laying out the two dominant paths to financial independence: The 4% rule and the income replacement rule.

I think that financial independence is actually a desired goal we're planning for, not the strategy we use to estimate what it will take to get there. 

The 4% rule was invented by William Bengen in the 80s or 90s – I’m not going to look it up for the purpose of this post – to describe how much in assets from a balanced portfolio could be feasibly spent without greatly raising the possibility of retirement failure, with retirement failure defined as a total drawdown of available savings. Bengen pegged this percentage at 4 percent annually, give or take a few tenths of a percentage point. 

If I saved $1,000,000, I could spend $40,000 a year out of it without drawing down my savings. The rule also means that, for financial independence, or a successful retirement, the average person needs to save 25x their estimated annual expenses. So if I needed $100,000 each year for estimated annual expenses, I would need to save $2,500,000.

The income replacement rule has more to do with a particular brand of investing, namely, income investing, and more specifically, dividend investing – because it’s the dividend aficionados who make up the bulk of practitioners using the income replacement rule. It simply states that by the time your investment income equals your career income, you’ve achieved financial independence or are able to retire.

Say my household pulls in $150,000 a year in income. Once the cash flows kicked off by my investment portfolio equal or exceed $150,000 a year, I'm done and can go live someplace with a pool and jacuzzi within walking distance of a beach. It should be noted that this is difficult to achieve with low-cost, efficient passive investing methods -- the S&P 500 has offered a dividend yield lower than 2 percent in recent years, meaning a very large allocation to the S&P 500 would be needed to generate sufficient retirement income. 

I can – and will – take potshots at both of these methods of estimating when you've reached financial independence. For example, I don’t think most do-it-yourself investors using the 4 percent rule are considering how difficult it is to estimate or anticipate their expenses for a retirement that may be 10, 20 or 30 years down the line – and for most financial independence-minded folks, I don’t think they’ve though what 30, 40, 50, or 60 years of retirement costs, expenses and surprise life events could mean for their well-laid plans. I don’t think income replacers think enough about diversification and the correlations within their investment portfolios, and what can happen when a long-growing, long-safe dividend payer takes a prolonged, deep turn for the worse that includes dividend cuts. Income investing also has tax and asset location implications that only a relative few investors are able to cope with.

Both methods ultimately fail to work for me because they are terribly vague and rigid at the same time. A good financial independence and/or retirement plan should be both specific to an individual’s needs, and flexible enough to handle the many curves and bumps a long, interesting life involves.

Like the Physician Philosopher, I tend to use both of these methods when figuring out how much I should save and how far I am from potentially retiring, but I acknowledge that they are far from accurate and not really practical for budgeting and saving. At most, using 4 percent rule and the income replacement method are quick, rough estimates.

But that is yet another one of my digressions. The Physician Philosopher does well to discuss these methods, but doesn’t really define financial independence. These methods may be paths that can ead a person to financial independence, but they aren’t the definition. 

Financial independence cannot be quantitatively defined - what it takes to achieve financial independence might be boiled down to an equation, but it would be a different equation for every person who chooses financial independence as a goal. Similarly, we have to leave open the possibility that financial independence might mean more than achieving a mere savings goal or investment income goal - it might also involve freedom from bill paying, budgeting, saving, asset location and investing altogether. Some of us might not feel financially free until the only thing left that we have to do with our money is spend it.

To me, financial independence is certainly not an investment technique, or a real estate scheme, or a lottery ticket. It can be found by those who achieve wealth via investing, real estate management or winning the lottery, but more often than not it isn't - which is why wealthy investors often live stressful lifestyles and experience family problems, real estate investors and house flippers can become bogged down as the quantity of their investments and complexity of the work grows, and lottery winners - all three, actually, but lottery winners especially - are prone to running through their wealth. Financial independence has as much to do with my intellectual and emotional relationship to money as it does the money itself.

To some people, financial independence may mean the freedom from money. In that respect, it's possible to be a perfectly happy penniless ascetic begging outside of a temple - and technically be financially independent.

At this point in my life, I would more specifically define financial independence as the freedom to make life decisions without having to consider the impact of added expenses and/or lost income. It’s the ability to spend time how I want. It’s the ability to invest in what I want – or divest from what I want. It’s the ability to work where and with whom I want, when I want. It’s the ability to live where I want. It’s also the ability to spend whatever I want, on whatever I want.

If someone’s ability to leave work involves making concessions on their living conditions – downsizing their house, moving to a cheaper area or buying cheaper food, lifestyle – not drinking if they want to, not going out to eat, or not being generous, or goals – putting off starting a family or not getting an advanced degree – then they’re not really financially independent, are they? They’re really just rearranging the furniture to avoid formal work.

By the same token, if someone has to constantly worry about the allocation of their portfolio, or how much they can withdraw from their account, or whether their dividend income is still growing - how truly financially independent can they be?

That's my $0.02 on the matter.


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