I used to know this guy, let’s call him “Lance”, who carried his pay-stub in his pocket at all times.
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.
Hi there. Thanks for stopping by. We use affiliate links to keep this site free, so if you believe in what we're trying to do here, consider supporting us by clicking! Thx ;)
Build a Portfolio Like Ours: Check out our FREE Investment Workshop!
Earn a 2%* everyday interest rate. No Everyday Banking Fees.: Open up an EQ Bank Savings Plus Account! (Canada only, excluding Quebec)
LIMITED TIME OFFER: Earn up to 4% cash-back (Canada): With Tangerine's Money-Back Mastercard!
Travel the World: We save $18K a year by using AirBnb. Click here to get $40 off your first booking!
Don't Pay FX fees: We used the Scotiabank Passport Visa Infinite card to eliminate foreign exchange fees around the world! Plus, we got 35k points in the first year, and free airport lounge access too! Click here to sign up!
*Interest is calculated daily on the total closing balance and paid monthly. Rates are per annum and subject to change without notice.