How Much Do You Need To Be Financially Free
“To know when you have enough is to be rich beyond measure.”
Lao Tzu (Chinese philosopher)
How much money is enough?
In our previous blog post, we delved into the significance of financial freedom and why it is essential for all of us to strive towards it. Understanding the concept, however, is merely the first step. To truly embark on the journey, we need a guiding north star — a tangible and achievable goal that we can write down and work towards.
Imagine someone asked you how much money you would need to quit your job. Would you be able to provide a precise answer? Many individuals might respond with an arbitrarily large number like $50 million or $1 billion. There are two inherent issues with such responses. Firstly, they lack grounding in reality, and unrealistic goals tend to remain unaccomplished. Secondly, and perhaps more importantly, these responses miss the point entirely.
Financial freedom is not about amassing vast wealth for the sake of it; it's about accumulating enough — a sufficient amount that allows us to live life on our own terms. After all, money is merely a means to an end, not the end itself. If we believe we need an exorbitant sum to achieve freedom, we will forever be bound.
With that, let’s get down to brass tacks and determine what a realistic financial freedom number looks like.
Introducing the 4% rule
The 4% rule was a guideline developed in the 1990s by financial planner, Bill Bengen, to assist retirees in determining the ideal amount they should withdraw from their retirement funds annually. According to this rule, individuals with a diversified portfolio comprising of stocks and bonds can safely withdraw 4% of their total holdings without the risk of depletion. Let’s break down a quick example.
Imagine you have diligently saved up $1 million for your retirement. Congratulations are in order! According to the 4% rule, you can securely withdraw $40K per year ($1 million multiplied by 4%) Does that number seem acceptable to you? If you were successful enough to accumulate $1 million before retiring — something most individuals never achieve — the chances are high that your annual income far exceeded $40K. After a lifetime of hard work, reaching the milestone of millionaire status, the prospect of downsizing your life may dampen your initial vision of living large during retirement.
To compound the matter, the 4% rule was designed with a 30-year timeframe in mind, aligning with the typical retirement age. Yet, if you aspire to retire earlier, the calculations shift, and the probability of success diminishes. The question then becomes: If $1 million is unlikely to provide a comfortable retirement, how much is truly sufficient?
The table above shows your chances of success (i.e. not running out of money) based on 3 factors - 1) A 4% withdrawal rate, 2) Your asset allocation between stocks vs. bonds and 3) How many years you have in retirement. The 4% rule was designed to be the most successful (most green in the table) for a 30-year time period (or shorter).
Facing the music: Calculating your number
As with most things in life, finances are incredibly unique. $1M might be the perfect retirement nest egg for a single person living abroad in Thailand, but it wouldn’t suffice for a family of four living in San Francisco. This is why it’s critical to do the work and understand what financial freedom looks like for you.
How to calculate your freedom number
Monthly Expenses: Calculate your monthly expenses
Annual Expenses: Multiply monthly expenses by 12 to annualize
Freedom Number: Multiply annual expenses by 25 (inverse of the 4% rule) to get your freedom number
While these calculations are straightforward, the prerequisite is understanding your expenses. Surprisingly, many people are unaware of their exact monthly or yearly spending. Don’t fall into this trap. The key to unlocking your freedom starts with knowing exactly how much you need. Let’s dive into another example.
Single person living in San Francisco:
Monthly Expense: $5,268 (according to this site)
Annual Expenses: $5,268 X 12 = $63,216
Freedom Number: $63,216 X 25 = $1,580,400
So, if your monthly expenses are around $5K a month, you would need roughly $1.6M to comfortably retire with an annual salary of $63K. This is just an illustrative example, but this simple exercise is extremely powerful. Take a moment to reflect on your own financial freedom number. Does it evoke fear or excitement? Most importantly, do you have a well-crafted plan and strategy to reach that number?
Now that we’ve talked at length about the 4% rule and its practical applications, it’s time for me to expose a significant flaw with this methodology: it assumes that you are relying exclusively on stocks and bonds to support your retirement. This myopic focus disregards an investment vehicle that holds a special place in my heart: real estate.
What if I told you that investing in real estate could dramatically reduce the amount of money you need to retire?
Real Estate: Supercharging your path to financial freedom
There are a number of reasons people choose to invest in real estate, but chief among them is cash flow. By acquiring the right properties, the rental income generated can surpass expenses, resulting in positive cash flow. It is this cash flow that can change the calculus of your financial freedom.
In contrast to the conventional 4% rule that necessitates liquidating your portfolio of stocks and bonds, real estate investing presents an alternative approach. Imagine owning a portfolio of 10 rental properties, each generating a monthly cash flow of $500. This equates to $5K per month or $60K per year. Comparatively, the 4% rule would require an investment portfolio of approximately $1.5 million to achieve the same $60K annual income. The question arises: Is it easier to amass $1.5 million in stocks and bonds or acquire 10 cash-flowing rental properties?
Let’s break down the numbers and find out!
Rental Properties vs. The 4% Rule
I’ll dedicate a future blog post on how to analyze an investment property, but for this post I’ll just introduce one metric: Cash on Cash return % (CoC %).
Cash on Cash return % = Annual Cashflow / Cash Invested
Example: I put down $20K (cash invested) to acquire a $100K house that generates $2K in annual cash flow. The CoC % of this property is 10% ($2K / $20K)
The CoC % measures the speed at which your money multiplies and the time it takes to recover your initial investment. In the example above, it would take approximately 10 years to recoup your $20,000 down payment, after which the cash flow becomes pure profit. Understanding the CoC % is crucial as it allows for a direct comparison between real estate and the 4% rule.
4% Rule: Freedom Number = Annual Income Needed / 4%
Rental Properties: Freedom Number = Annual Income Needed / Cash on Cash %
If the Cash on Cash % from your real estate exceeds 4%, the amount you need to retire decreases. So, what is a realistic CoC % for rental properties? In my view, achieving an 8% to 10% CoC % is reasonable, although investors sometimes reach as high as 15% to 20% CoC %. One thing to note, is that cash flow tends to increase over time. As rents increase, profitability improves, leading to higher returns. Thus, with long-term ownership, real estate has the potential to generate substantial cash flow (while retaining ownership of a valuable asset).
To tie all these concepts together, let's turn to a visual aid. I found this awesome table from Rental Income Advisors that beautifully illustrates this point.
Following the table above, to generate $60K a year in retirement income you would need $750K invested into rental properties that were generating a 8% Cash-on-Cash %. That cuts your freedom number in half vs. the 4% rule, which calculates that you would need $1.5M in stocks and bonds. If you are able to acquire properties with higher CoC%, the amount invested continues to drop.
This exemplifies the power of real estate as an investment strategy.
Wrap Up
If you made it to the end of this post, thanks for sticking with me! I know there was a lot of math, but figuring out exactly how much you need to achieve financial freedom is a noble pursuit. Too many people accept that retirement is an event that’s way off into the future, and as a result, don’t take the necessary actions today that can make retirement easier (and happen much sooner). I encourage you to think deeply about when you want to retire, how much you’ll need, and devise an investment strategy to make that happen. I hope this post has provided valuable insights and guidance on your path to financial freedom.
Stay committed to the journey, my friend. Your future self will thank you.
