How should you go about determining how much wealth you need to build throughout your life?
When do you re-evaluate that perhaps you should start slowing down? We get bogged down by the prospect of waking up daily in our high stress, high responsibility work, always over-worrying some things may go wrong.
If your next year’s expense is $20,000/yr, and your wealth machine(s) generate cash flow at 5%/yr, you will need $20,000/0.05 = $400,000 in your wealth fund.
So little? How did I derive this amount, and what is your wealth fund and wealth machines? Read on.
Defining Financial Independence versus Retirement
The misconception of how early retirement looks like is one where you go on holidays every week or sit at home do nothing. I realize that if you are at 45 years old and you have enough to retire, you might live as long to 100 years old with advances in medical technology.
That would mean 55 years in retirement.
At some point going on holidays and doing nothing would eventually feel like another job .
In that sense, a 35-50 year olds mind is rather active, and a sudden change in environment to an aimless one can be quite detrimental. A feeling that suddenly no one depend on you anymore may make you feel rather useless and perhaps a reason why a lot of health problem occurs after retirement .
If you read the Sunday Times and they keep asking these folks when they want to retire or what they will do in retirement, they gave the same answer.
They don’t want to stop working.
A better definition for retirement is rather financial independence (short form here FI ).
Financial Independence is define differently for a lot of different people. To me it’s a long these lines
- I have a cash flow that should something happen in my job that I don’t like, I can walk away from it
- I have the option to get out of my passionless job to focus on something I always wanted to do
- I have the option to slow down and take partial work, on my own terms
- I can devote to other life goals
In short it is as if you are working BUT tilting it to more of your own values.
Calculating how much you need to accumulate in FI
Let us call the fund you need to accumulate for FI be Wealth Fund.
The size needed depends on:
- Your expenses in FI
- Your Wealth Machine’s Rate of Return
- Inflation rate in FI
In short it depends on the following 2 equations:
- Wealth Fund required in FI = (Next year’s Expenses in FI per month x 12)/Rate of Return to generate cash flows in FI
- Rate of Return of your Wealth Machine(s) required in FI = Rate of Return to generate cash flows in FI+ Rate of Return to keep up with Inflation in FI
In the next 2 parts, I will explain why the size of your Wealth Machine funds is determined by 2 equations.
What is your Wealth Fund and your Wealth Machines?
To put it simply, your wealth fund is a layered look at the money you save that is allocated to work harder for financial security or independence. Your wealth machines, are methods of building wealth with different financial instruments.
Why do you need to understand this layer in your Wealth Building? I have written a comprehensive article on why you need this before you dive into stocks, fund investing, and property investing.
Do read the article and see how the wealth machine’s rate of return impacts the size of your wealth fund required.
Part 1: Its all about generating cash flows for FI
You probably have read about wealth building and have your way of building up your wealth.
You have manage to accumulate $X through fundamentally sound wealth building with whichever wealth mechanisms up to this point.
The sum of money you accumulated, or $X objective. is to generate a stream of cash flows that can support your expenses during your FI .
The methods you use to provide the stream of cash flows to support your expenses can be different from how you build up the wealth in the first place.
The misconception is that, in FI, you need passive income, either stocks or bonds that give out dividends and interest consistently. or a rental property that people give you rents .
There are other wealth building mechanisms or what I would term Wealth Machines (since any mechanism whose job is to help you build wealth can be termed as such). You can review them in the able below.
If you have accumulate a fund or ETF that does not give out interest or dividends. the asset value builds up to say, $400,000 with 40,000 units.
You can sell Y number of units quarterly to fund your FI. (Note: if you are drawing down units or shares do note that your asset value may fluctuate in FI and it may affect you. For more information read this )
Either way, FI is about achieving a cash flow that is able to cover your expenses .
Wealth Fund required in FI = (Next year’s Expenses in FI /mth x 12)/Rate of Return to generate cash flows in FI
- Next year’s Expenses in FI /mth. How much expenses you need to cover in financial independence. We will go into this later
- Rate of Return to generate cash flows in FI. This is your long term rate of return of your way of wealth building during the period of financial independence to generate the cash flows to distribute an annual amount to you.
Suppose 45 year old Jack calculates that in financial independence he needs to cover $1,666 per month of his expenses. That will give him enough buffer to work with. He intends to put it in corporate bonds with a rate of return of 3.33% (this is his chosen Wealth Machine).
He would need = (1,666 x 12)/0.0333 = $600,000
So if Jack have accumulated $600,000 or if the next 5 years he sees that he can accumulate that much, he can seriously consider if he is ready for FI.
Part 2: The Rate of Return of your Wealth Machine(s) over Inflation
If Jack thinks $600,000 is all he needs to consider then he is missing something out.
In order for his cash flow to provide him with the adequate purchasing power for the next 40-50 years (long time!), he needs to make sure that the $600,000 wealth fund needs to grow with inflation .
This will mean that Jack’s wealth machines will need to keep up with inflation, in excess with the rate of return to generate the cash flow for FI .
Rate of Return of your Wealth Machine(s) required in FI = Rate of Return to generate cash flows in FI + Rate of Return to keep up with Inflation in FI
Jack sets a conservative target for his Wealth Machine to generate 6.33%/yr .
If Jack assumes inflation over the long run to be 3%/yr, then he can only spend 6.33%-3% = 3.33%/yr.
The table below shows over 55 years, how Jack’s expenses can maintain the purchasing power @ 3%/yr inflation. while continuing to provide Jack with cash flow from his Wealth Fund, and not seeing his Wealth Fund depleted.
Let me try to explain how to look at this table.
Jack successfully put away $600,000 at age 45 years old into his Wealth Machine Fund, which will be able to generate $20,000/yr in the first year to meet his expenses.
This $20,000 will go up with inflation, but the amount left over, after withdrawing this $20,000 would be enough for Jack to generate an amount equivalent to $20,000 purchasing power for the next and subsequent years .
Confusing? Lets go through the first 2 lines in the table above.
At end of 45 years old
At the end of 45 years old, Jack will have $600,000. Based on his wealth building vehicle, be it property, stocks and bonds, Jack generates $600,000 x 0.0633 = $38,000.
Jack remains discipline to spend only 3.33%/yr, which means he can only spend $600,000 x 0.03333 = $20,000 for the start of age 46.
He will be left with 600,000+38,000 – 20,000 = $618,000 at the start of 46 years old to generate further growth.
This is how you read line 1 in the illustration above.
At end of 46 years old
At the end of 46 years old, Jack will have $618,000. Based on his wealth building vehicle, Jack generates $618,000 x 0.0633 = $39,140.
Since he remains discipline to spend only 3.33%, he can only spend $618,000 x 0.03333 = $20,600 for the start of age 47.
Notice that to have the same purchasing power of $20,000 at age 47 so that it is the same as age 46, your $20,000 will need to grow to $20,000 x 1.03 = $20,600, which is what your $618,000 generates.
He will be left with 618,000+39,140 – 20,600 = $636,540 at the start of 47 years old to generate further growth.
This is how you read line 2 in the illustration above.
Wealth Fund can be passed on when spouse passes away
The beauty of this conservative nature is that at any point when the couple passes away, this portfolio asset
can be passed on to the children or put into a trust where they can help make their life much easier .
Theoretically it never gets depleted .
To summarize, the size of the Wealth Machine Fund in FI depends on 2 equations:
1) Wealth Fund required in FI = (Next year’s Expenses in FI per month x 12)/Rate of Return to generate cash flows in FI
2) Rate of Return of your Wealth Machine(s) required in FI = Rate of Return to generate cash flows in FI+ Rate of Return to keep up with Inflation in FI
How long to reach Financial Independence – Depends on your channeling rate to your Wealth Machine Fund and Your Wealth Machine’s Rate of Return
Coming up with $400,000 – $600,000 can seem daunting and it very much depends on your ability to keep your expenses in financial independence in check, but also the rate of return to generate the cash flow for expenses in FI.
Suppose that instead of 3.33%/yr, the rate of return to generate cash flow in FI is 4%/yr.
Here is a table showing the number of years to accumulate that $400k, $500k, $800k to reach FI. Let me explain this table to you.
To accumulate the amount required for FI, you need to select the different kind of wealth machine and they will have various rate of return ranging from 1%/yr to 20%/yr.
You can vary your savings rate, or the amount you put away from your income to your wealth machine.
Observe that if you put a low savings rate of 20%/yr, the number of years to reach FI ranges from 69 years to 16 years. Your wealth machine rate of return is important here.
But if your put away 50%/yr to your wealth machine, the range is smaller from 22 years to 9 years. The wealth machine rate of return is less significant.
The lesson here is that to reach FI it is within your control to channel more to wealth building. The higher you do that, it matters less about the production ability of your wealth machine ( you can use an endowment life insurance versus a higher risk unit trust)
A high earner who puts away more into his Wealth Machine Fund, can use a Wealth Machine that generates a lower rate of return.
A medium earner or low earner who cannot put a high amount repeatedly into his Wealth Machine Fund (he can try!), would have to leverage on a Wealth Machine that generates a higher rate of return.
At the end of this section, I hope that you can see the linked between how much you put into your Wealth Machine and the rate of return of your Wealth Machine, with the amount needed to generate cash flow for your expenses in FI .
Planning with Conservative Rate of Return Estimates
I first heard of this from a US guy and he gives a rough estimate: If you need $1,000/yr in FI, you need $300,000 to support that. If you need $2,000 then its $600,000.
I was rather puzzled by that and if you use the formula in (1) the rate of return in wealth building in FI is 4%/yr.
A lot of the REIT investors will think “hey I can beat this with 7% yield and properties rental revise up with inflation”.
While that is true, remember that you are planning that you won’t depend on your job or business for a long period of time so it is imperative that
- your plan is fundamentally sound. If you think you can generate 7% + 3% consistently and you feel that you have enough buffer for mistakes then go ahead
- your plan needs to be compatible with the next phase of your life. You may not want to look after properties or be consistently looking at a screen for long duration but more meaningful things. Have you factored that in?
- your time commitment to wealth building in FI. You may not want this second job
- your brain capacity or cognitive abilities will weaken as age starts to catch up on you
It is why instead of using a 6-7% rate of return to generate cash flow, the guy uses 4%. The long term real return for a lot of markets are illustrated below
Unless you happen to invest in the super power known as US, you better hope that your competent skills are really competent for you to set up a wealth building skill that match the level of time commitment you desired in FI.
Else it is better to be conservative about it. Use safer more predictable lower return instruments and plan with a more conservative rate of return .
Planning conservatively – an example
The way to plan conservatively is to understand the average rate of return of the wealth building method in the country you deploy the money in. If you are purchasing real estate investment trusts (REITs) and bonds in Singapore, then take a look at the long term returns.
Once you have that, use the figure and drop 30% of it. So if you are gaining 6%/yr on average REITS + 2%/yr inflation growth, instead of using 6%/yr estimation, use 4.2%/yr instead.
If your expenses is $2000/mth, or $24,000/yr, you will need a sum of 24000/0.042 = $571,428. This is the conservative figure, where your expenses will grow at 2%/yr inflation growth roughly.
Could you use the 6%/yr figure? You can, but you have to know the caveats of using that. Returns do not go up in a straight line, they can be volatile and go up and down.
If you use 6%, you will need 24000/0.06 = $400,000.
This is a smaller sum that you can aspire to hit, and your 24,000 can grow at the 2% inflation. However, there will be years where you cannot withdraw the full 6%.
Planning conservatively – variable withdrawal strategies
The 6% Rate of return of Cash Flow required for FI creates a lower Wealth Machine Fund of $400,000 to aim towards. There are retirement or wealth builders who have limits, or that they have other life aspiration goals that they would want to spend more their time on instead of at work .
You can have a less conservative rate or return estimation provided you know the caveats.
Not just that, its better you have some ‘blueprint scripts’ that guides how you withdrawal your money from your Wealth Machine Fund so that they do not deplete your Wealth Machine Fund in bear markets due to sequence of return risks (read here why sequence of return risk matters ).
I have written a guide on variable withdrawal strategies that can guide retirees or people in FI to vary how they withdraw their cash flow from their Wealth Machine Fund, with a less conservative withdrawal percentage and still do relatively ok. You can read Variable Withdrawal Rates that make $500,000 possible in FI .
The unpredictability of inflation
Part 2 of the equation requires an estimation on inflation. And inflation is somewhat a function of the political climate that really, no one can actually predict.
It is why the most appropriate instrument are those that does better in an inflationary scenario. TIPS in the US, which are inflation indexed bonds that track the level of inflation.
Knowing your quality of life and your FI expenses
I tried explaining to people to track how they allocate their disposable income and one of my opinion is that if you don’t feel like doing it, you don’t really want to retire .
Part 1 of the equation hinges on an open conversation with yourself on what kind of life you can live with. Can your family make do with no tuition for the kids and you home school them, or is that a necessity?
Do you still value your designer bags or at that stage, its rather meaningless to you.
How much holidays per year during your FI?
All these will contribute to how realistic and how fast you can achieve FI.
$1,666 per month may seem very little, but considering that amount is not including, wealth building, emergency funds, mortgage, all of which should be fully taken care of by then.
You might be more comfortable working with $2,500, which means you need a bigger sum.
This provides you with a direction to FI but not the final solution
What is provided here is not the blue print to reach Eden but it sets you to the right direction .
By no means should we limit ourselves or push ourselves hard in our journey to financial independence. We all have different risk appetite and different competencies.
We hope that this puts questions in your head and sets you in motion to discover whether you can aim for a finite time period to reach the FI state.
So perhaps start today and have a conversation with your spouse, whether both of you can sacrifice a bit to work towards a state of life where you can move on to do something you like.
If you have reach FI, let me know how did you determine you are ready for it.
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