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I used to know this guy, let’s call him “Lance”, who carried his pay-stub in his pocket at all times.
Why?
So he could brag about his big fat, 150K salary to everyone he knows….and doesn’t know.
Who even does that, right?
Well, apparently when you have a community college degree but all your co-workers have engineering degrees, you end up with a HUGE chip on your shoulder.
And with a paycheck that huge, it should be easy for him to become Financially Independent, right?
Well, let’s find out…
To become FI, 4% of his investment portfolio (P) must be enough to cover his expenses (E):
If we express Expenses as a function of Income (I) and %Savings Rate (S), we get:
Now, substituting 0.04P for Expenses:
And if we add in a 30% safety margin (for unexpected market downturns, emergencies, etc), we get:
If we express P as Money Saved + growth (known as Future Value of Annuity):
Wait. What’s going on here? What’s I doing on both sides of the equation?
Holy crap! That means we can cancel them out!
Whoa. Do you know what this means?
Income doesn’t matter! Only Savings Rate does.
And in Lance’s case, since he spends $135K/year and makes $150K, his savings rate is 10%.
So how many years until Lance is FI?
If we solve the above equation for N (Number of years), we get:
Now, that equation may not mean much yet, but look what happens when we graph it using an investment return (r) of 6%:
With a savings rate of 10%, Lance can continue bragging about his pay-check, while watching his co-workers ride off into retirement, one by one.
Because Lance will have to continue working…for another 50 years.
A bigger pay-check didn’t help him much, did it?
But what if he were to get a higher investment return?
If Lance’s investment return is 10% instead of 6%, he can retire in 35 years, instead of 50 years.
But that’s still a LONG time.
In fact, looking at the graph above, we notice:
At a savings rate of 10% or less, everyone has to work 35 years or more.
But what about higher savings rates?
As you can see from the graph above, at mid-range savings rates (40-50%), your investment returns have a pretty big effect.
You could end up working 20 years less, with a return of 10% versus 1%.
And what if your savings rate was 60% or more?
Shockingly, at high savings rates, investment returns barely matter at all! In fact, the more you save, the less investment returns matter.
So what does all of this tell us?
The size of your paycheck doesn’t actually matter
The only thing that matters is what you do with it
At savings rates of 10% or less, you MUST work 30 years or more
At savings rate of 40-50%, your investment returns can speed up your retirement by as much as 20 years
At savings rates of 70% or more, your investment returns don’t really matter and you can retire in 15 years or less.
Do you have a “Lance” in your life?
If so, remember this next time he smugly whips out his pay-stub:
The size of his pay-check doesn’t matter. It’s what he does with it that counts.
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No comments ?
Your math scares people…
I trying to be brave …
A girl doing math scares people? Man, am I glad I wasn’t born in the 16th century. They’d burn me as a witch.
did you just put words in my month? O.o
Math scares me, women not anymore..
I do get the point and referring to another post .. Watch where your money is going.
So two protips there
1. It isn’t the seize of your income, but what you do with it
2. Watch your stuff, cause it might grow legs and run away.
P.S. Don’t piss off CRA.. Almost forgot that one
mouth* … ugh is there a edit button?
Sorry, my radar’s a little sensitive from all those…purvy Blog Dog comments.
I understand comrade.
Well, income does matter because you have to live somewhere and eat somethings…but I get what you mean about savings.
Live well under your means…this has been our motto and yes we are now .01%ers.
Good job and welcome to the 1%!!! Prepare to be hated.
Yes, I think the key is to understand the cycle in various stages: in the accumulation phase when the person is 25 years old to 35, 40 etc. working and saving the portfolio returns (almost) don’t matter because the portfolio size is so small; on the first day of the job when there is a $0 portfolio and $50,000 income then only the savings rate matters, the investment return rate starts mattering more and more as the portfolio size grows (and conversely the importance of the savings rate drops equally) until day 1 of retirement when it is completely reversed: savings rate doesn’t matter and only investment return rate matters (assuming the simple case of just using the returns on the portfolio to live on, not the more complicated case of trying to save a bit of the returns every year from the portfolio itself in retirement).
It is very important to understand that living on less has a double bonus: not only do you save more by doing it during accumulation but you require less during retirement. It should be very comforting because your spending (above a certain limit) is very much under your control whereas investment returns really aren’t.
Exactly. I think as I meet more and more FI people, the common theme between us is the ability to control costs. Lots of other details differ, but that’s the one thing we all have.
“It is very important to understand that living on less has a double bonus: not only do you save more by doing it during accumulation but you require less during retirement.”
Exactly. And not understanding this “double bonus” is exactly why most people don’t bother saving. They figure, hey, it’s going to take decades to retire because the financial industry keeps telling them they need to replicate their salary in retirement. Nope. It’s all about your savings rate.
The 10% savings….. In terms of actual dollar what would be the amount
Reason for asking this, i have loans and credit (Educational and personal. No mortgage yet!!!) and need to clear it to begin any investments. But my company offers Defined contribution plan and i dont want to miss it. So if i can come up with the exact amount can increase savings upto 20% with matching from the company. Then as i clear loans will go for higher percentage savings.
Would this work!!!!
Yes, this makes sense. I know you have loans and credit, but like you said, it doesn’t make sense to miss out on your company’s DC matching. Depending on the rules of your DC plan, you might be able to withdraw it to pay off your loans. That would be win-freaking-win!
Hi FC,
This is a marvellous and simple way to FIRE. People tend to ignore such analogy and assume that the route to FIRE is difficult and lead them to give it up so easily.
WTK