By: AnnaMarie Mock, CFP®
In Part 1 of F.I.R.E., we explored the meaning behind the movement and the different variations, while Part 2 of F.I.R.E. provided some context on common misconceptions. With that backdrop, we are going to outline how to quantify your definition of F.I.R.E.
Defining your F.I.R.E. plans and establishing goals:
Although saving, in general, is integral to success, you need to know what you are saving towards and why. By starting with goal setting, it will inspire you to make your goals a reality. The definition of financial independence is unique and varies from person to person; be introspective and ask yourself the following questions:
What does financial independence look like to me? As laid out in Part 1, there are three main types of F.I.R.E. – Lean, Fat, and Barista.
What is most important to my work-life balance?
Are my decisions dictated by the need to earn money or the goal of financial freedom?
Do I want to retire when financial independence is fully achieved, or do I want the ability to choose the work I enjoy without being concerned about salary?
Calculating your magic number:
The magic number is an estimate of what is needed to attain financial independence. This is not an end-all-be-all method, but it morphs an intangible idea into a concrete goal. The figures used to get to the magic number should reflect your current cash flow patterns. Just like a business, you want to focus on what’s coming in (income), what’s going out (expenses), as well as what’s being retained for the future (savings).
To start, you need to determine your annual savings. This should include employer-provided matches, your investment accounts, and your savings accounts not being consumed for daily lifestyle expenses. This annual savings figure is the powder that will increase your investable wealth and generate long-term growth.
Next, your current lifestyle expenses indicate the amount needed in your portfolio at your retirement age to sustain that lifestyle. This is where tracking expenses should become a habitual practice. Add up all your costs, not including taxes or savings. An easy way to categorize the remaining costs is to group them as either fixed or discretionary.
Fixed expenses. These are items you must pay every month to maintain your current household, such as your mortgage or rent, car payment, insurance premiums, and utilities. Generally, the amounts will not change on a month-to-month basis.
Discretionary Expenses. The joy of life is doing what you love. Whether traveling, hobbies, or dining out, this section gives you the flexibility to spend on the ‘fun stuff.’
The bottom-line amount is what you are projecting to spend throughout your retirement. Take the annual expense amount and multiply by 25; this is the magic number
For example, Timmy spends $100,000 per year, so he would need $2,500,000 ($100,000 x 25).
Lastly, calculate how long it will take you to accumulate the magic number based on the amount you save each year (part of step 1 above). This will require you to assume investment returns.
For example, based on an average annual return of 6.5% and annual savings of $30,000, it will take Timmy 30 years to save up to the magic number of $2,500,000. Instead, if Timmy cuts back on expenses and saves $40,000/ year, it will only take him 26 years.
The more you save, the sooner you’ll reach financial independence.
Creating a savings plan to get to that lifestyle:
A spending plan is a blueprint for your money and gives you an actionable plan to spend your money intentionally without guilt and fear of overspending. This is not designed as a strict budget. We get it; life happens! There will be months with higher outlays than usual, and the objective is to be prepared for those unexpected months while having sustainable money management skills. Mindful spending is awareness of how you think, feel, and act with money.
The amount you identified should be the savings target for the foreseeable future until your goal is completed. Automatic savings can systematize the process and ensure this is done regularly. Think of automated savings as a fixed expense where you are paying yourself just like you would any other bill.
Recognizing The Risks with F.I.R.E.:
Firstly, Cash flow and goals will fluctuate as your life evolves, making the magic number a moving target. The future is unpredictable, so if progress is not evaluated regularly, there could be unexpected issues. Keep in mind that there is no guarantee that your projections will occur as mapped out.
For example, based on Timmy’s initial review, as explained above, he has been saving $30,000 per year for the past five years, so based on an average annual return of 6.5%, he has $170,810. He has been working towards his magic number of $2,500,000 based on expenses of $100,000 per year.
However, Timmy has not reevaluated his savings plan for the past five years. Timmy received a raise two years ago and has been spending an additional $20,000 per year, which he expects to maintain during his definition of retirement. This means his new magic number is $3,000,000!
Secondly, the stock market can be erratic, but it is necessary to participate in it for capital appreciation. The primary reasons to take the risk are to achieve a higher return than inflation and fund specific goals by forecasting additions to capital (portfolio savings). If portfolio returns do not meet expectations, that can lengthen the time to achieve the goals.
For example, if Timmy’s portfolio earns 5.5% over five years, he would have $167,500. Although this seems insignificant, the lower rate of return adds three additional years onto his financial independence horizon.
Investing in a diversified portfolio can mitigate some risks of being in the markets, making the investing experience smoother. Stick with an investment strategy designed to weather all types of events but provide the long-term return needed for your plan. Multiple scenarios of investment outcomes should be run to test the validity of your plan and consider worst-case scenarios as a stress test.
Working With an Advisor
Rather than relying on a generic approach, work with a financial advisor to analyze your current spending and what that would look like over time. The process of financial independence takes a more thoughtful approach and working with an advisor will likely provide the best chance of success.
A financial plan does not need to be complicated and should provide a starting point for measuring your long-term success. Financial planning is as unique as you are, so a remedy for one person may not be appropriate for your situation. Planning allows us to be proactive rather than reactive in shaping our lives because we have more control over the outcomes.
This is a very dynamic process that will reduce your stress about money, support your current needs, and build assets for long-term goals. To grossly oversimplify this, you want to focus on four things: investing in your professional/ personal growth, spending less, saving more, and investing prudently.
AnnaMarie Mock is a CERTIFIED FINANCIAL PLANNER™ and Partner at HIGHLAND Financial Advisors, LLC, a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, employer retirement planning, and investment management. AnnaMarie graduated from Montclair State University with a degree in finance and management and successfully passed the CFP® national exam in 2016. She has been working at Highland Financial Advisors since 2013 as a fee-only, fiduciary Wealth Advisor and is a member of NAPFA.