How to calculate you Financial Freedom Number?

Background: Annual income is an indicator of ‘how much my time is worth in dollars? For example, $60k is what my gross earning that comes from my 9-to-5 job. When you are financially free, you do not need to work, your time is worth an infinite amount. Then you don work for others. Let us take an example of a trader with a $50,000 capital account. There are 2 main objectives when trading:
1. Trading for growth: Manage your small account of $50k and grow it into a bigger one like $100K. During developing and growth period, usually you don’t withdraw funds out of your trading account. The goal is to multiply your current account size to many times. You use a trading strategy that delivers consistent and predictable returns. On top of that a trader needs an effective money management.
2. Trading for income: Once your growth account is large enough (from above example $100K),  you start “trading for income”.  Income means you’re regularly transferring money from trading account into your personal account for expenses .You maintain a certain account level for capital, and transfer funds anything above this level.  Trading for income consist of more conservative trading strategies and money management. Why very conservative?, because now you only need to make 5% per month or 60% per year to have a nice income. An income of $60K is 60% of $100,000!

What might you like to do in life after retirement?

Steps to calculate your Financial freedom number: 

First thing first, determine the cost of your retirement goals and lifestyle.

Determine Retirement Goals : Decide your retirement goals and list them. They can be things you’d like to own, do, give, etc. Retirement planning starts with setting goals you want to achieve one day down the road and realizing that your desired lifestyle can come true. Here are some questions to help prompt your list:

1. What age would you like to retire?
2. Where do you want to live? What city, state, country?
3. How expensive of a home do you want to own? How many bedrooms, square footage, how many bathrooms?
4. Do you want to have two houses and travel among the two based on seasons?
5. How many vehicles will you own? What make and model would you like?
6. Will you be eating out often or will groceries still be a large portion of your food expense? Higher end restaurants and dining out?
7. What vacations and traveling will occur? What is your dream vacation?
8. Does the state you live has a state income tax? What’s the property tax rate in that state?
9. What activities you will be engaged in after retirement. Look at following examples:

  1. Part time job
  2. Hobbies
  3. Volunteer work
  4. Learning
  5. Relaxing and enjoying life
  6. Traveling
  7. (Add to this list..)
 Step 1 – Calculate living expenses: You’ve listed your retirement  goals, you’ll need to come up with an estimate of what this lifestyle will cost you per year in today’s dollars. Spend time researching different cost estimates of the activities, vacations, and things you expect to spend on each year if you are unsure. This will give you a more accurate lifestyle cost estimate if you’ve looked up the costs online to get an idea rather than just guessed. To predict accurately, check over the last 6 months of your expenses from bank and credit card statements. Here are general living expenses you should take into account:

Property Insurance
Property Tax
Property Maintenance & Repair Expenses
Lawn Care
Utilities (Electric bill, cable bill etc.)
Car(s) Payments , fuel, insurance and maintenance
Internet Service
Cable Service
Phone Service
Dining Out
Health Care & Insurance
Dental & Medical Expenses
Clothes & Apparel
Vacation & Travel
College Loans (Yours or Children’s)
Credit Card Payments
Other (groceries, Netflix subscription, tuition, mortgage or rent, a few dinners out, a movie, mortgage payments)

Here are a few life events that you should set aside a small savings bucket for in your budget:

Buying a Home
Starting a Family
Children’s College Fund
Emergency Fund/Rainy Day Fund

After include everything from expanses, suppose this amount is $4,000 a month. Add 10% wiggle room and round it up to $4500 monthly or $4500*12 =$54,000 annually.
This is your Freedom Number of $54,000. This means an additional $4500 a month income is needed to achieved financial freedom.

Determine the ‘Nest Egg’ needed at retirement : How much money do you need in your retirement nest egg to sustain your retirement cost of living?  You have calculated annual expenses of   $54K above, multiply this expected cost of living by 25.

The 4% withdrawal solution by William Bengen: 

The 4% is a popular rule-of-thumb to answer question of Nest Egg calculation.  If you retire at 65 years you can withdraw  4% of your Nest Egg each year and expect your portfolio will last at least 30 years. Some 22 years ago in 1994, California financial planner William Bengen conducted a study on U.S. data on stock and bonds returns since 1926 to find balanced portfolio called Nest Egg, Bengen determined that if you followed this strategy during any 30-year period between 1926 and 1993, you would have never run out of money.

4% withdrawn each year plus annual inflation adjustments to last 30 years(retiring at age 65 years and life expectancy of 95 years). But 4% rule is not bulletproof, given future uncertainties , interest rates and rate of returns.

Age divided by 20 rule:

Evan Inglis, SVP at Nuveen Asset Management, recommends divide your age by 20. Example: someone who is 70 could safely spend 3.5% (70 ÷ 20 = 3.5) of their Nest Egg. Couples use the younger spouse’s age.

Nest Egg Needed = Cost of Living in Retirement x 25

The number 25 is a safe number of cash flow lasting for 25 years after retirement.

This math can be difficult to wrap your head around, but simply you expect to earn 4% or 1/25 of your investment account. So you would need 25 times your living expenses invested in assets. The 4% return on investment to cover your cost of living and not have to pull from your investment account to fund expenditures. You need 25 times your cost of living ($54,000 as calculated above) as shown in following example, using 4% because of inverse relationships (1/25 = 4%).

$54,000 per year lifestyle = 4% interest x Nest Egg
$54,000 / 4% = $1,350,000 needed in Nest Egg
$1,350,000 / $54,000 = 25 times cost of living

Step 2 – Calculate ‘Annual Savings’ to reach ‘Nest Egg/ Financial Freedom’ goal

You’ve calculated $1,350,000 towards your nest egg number that you need invest in step 1 above. To accumulate that amount you need to save ‘some amount’ each year to accomplish nest egg goal. Variables like Time, Interest, and Amount are important in investment equation and affect how much you’ll have in your nest egg. Time is determined by your current age and interest rate or rate of return is direct result of investment choices (Asset classes you select).

  • How many years are there for your retirement age goal?
  • What average rate of return on investment you expect during these years in above question?

High Risk/Growth = 8% to 12% (If you are young and have high tolerance for risk)
Medium Risk/Growth = 6% to 7% (The historical average return for the stock market is 7% since 1871)
Lower Risk/Growth = 3% to 5% (Bonds return are historically 3-4%, Keeps inline or ahead of inflation and if you are risk averse)

Play around with this calculator, change time, amount invested each year  and percentage growth rate to come up with a plan that meets your needs.Here are some examples:

Saving $10,000 per year for 40 years at 7% in RRSP and TSFA, will get a retirement nest egg about $2 million. (Medium risk)
Saving $10,000 per year for 30 years at 7% ,will get a retirement nest egg about $944,000. (Medium risk)
Saving $20,000 per year for 25 years at 9%, will get a retirement nest egg about $1.7 million. (High Risk)
Saving $20,000 per year for 35 years at 9%, will get a retirement nest egg about $4.3 million. (High Risk)

Young investors seek growth stocks with 10-15% annual returns, as many years are ahead of them and can invest in risky investments. Time is so important, if you start saving and investing early on, the power of compounding interest can get you to a big nest egg by retirement. You can retire early once you reach your nest egg goal. If you are late to the party, time and interest are against you as investors, you have to save a lot more to invest each year  at this point making it difficult to achieve lofty retirement goals. These investors generally start shifting their portfolios to lower risk investments because they don’t want to risk losing years of hard work and income. This results in lower returns usually as they do not want high risk investments.

Do not like Investing in stocks, get nest egg via rental properties:

Let us figure out how many rental properties it would take to cover our $4500 per month. Most of them rent between $900 to $1000 a month . Each of these houses cost roughly $500,000 , but for now we’re only concerned with an easy rental average of $1000 per month.

Conservative estimates:

Rent of $1000 per month and account for an additional 40% for vacancies and repairs, And $1000 x 0.60% = $600. Worst case scenario will get $600 per month on this property.

Expense amount of $4500 and divide it by $600 to get 7.5, round it to 8. That means 8 properties will produce a cash flow of $1000 each (minus repairs, vacancies, etc.) or $600 a month is all it would take $4500 per month.

Add up your monthly expenses and pad it by 10%. Then take the average single family rental $1000 X 0 .6 (vacancy and repairs) = $600. Take your monthly expenses $4500 and divide that by 600. You’re left with 8 so it would take simply 9 rental properties to produce $4500 per month.

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