Financial independence

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Financial independence is a state in which an individual or household has sufficient wealth to live on without having to depend on income from some form of employment.[1][citation needed] Financially independent people have assets that generate income (cash flow) that is at least equal to their expenses. Income earned independent of a job is commonly referred to as "passive income" and is the foundation for achieving financial independence.[2]

Background[edit]

In law, financial independence is defined as a person’s ability to spend their own resources to secure food, housing, and meet other living expenses.[3] However, the legal definition does not make a distinction between earned and unearned income; either or both may be used to make the determination.

The best-selling book Your Money or Your Life redefined financial independence as “having an income sufficient for your basic needs and comforts from a source other than paid employment.”[4] Although this has a similar connotation as being independently wealthy, a crucial difference is that the required wealth for being financially independent can be relatively low in an absolute sense if a person does not demand much in terms of “basic needs and comforts” or is able to secure them using non-monetary means. Although this insight has been understood and previously communicated in other written works (most notably Walden by Henry David Thoreau, but also by Ralph Borsodi and Scott Nearing among others), Your Money or Your Life is arguably the most influential book in recent history to reframe financial independence relative to individual needs.[5] It has been credited as an inspiration by many writers and bloggers in the FIRE movement.[6][7][8]

The concept of financial independence gained mathematical rigor with the publication of Jacob Lund Fisker’s book Early Retirement Extreme which identified the savings rate as the critical parameter determining the time required to attain financial independence.[9] Fisker found that an individual could attain financial independence at a relatively early age provided that person could achieve and maintain a savings rate of 50% or above.[10] Furthermore, he demonstrated that such savings rates were attainable on a median income through application of creative lifestyle design and simple living strategies. The combination of these concepts is the foundation for the modern FIRE movement and has been popularized by Mr. Money Mustache[11] and others.

Definition[edit]

There is no single universally accepted definition or set of criteria for assessing whether a person or household is financially independent. This is because expenses are generally not known in advance due to fluctuations in the price of goods over time, so the minimum required amount of assets cannot be known exactly. In Your Money or Your Life, financial independence is defined as: [12]

In this formula, the time period used to determine the yield must match the duration over which expenses are incurred; a time period of one year is typically used. For investment portfolios including stocks where price appreciation is an important component of the return (that is, a total return investment strategy), yield is usually replaced with a withdrawal rate (WR) to account for the sale of assets over time to meet expenses. For financial independence, since it is not the absolute value of assets or expenses that matters, but rather the amount of assets relative to expenses, the above inequality is often rearranged to:

The quantity is sometimes referred to colloquially as "The Number"[13] , as it represents the amount of assets at which a person may consider themselves financially independent since capital income alone can meet expenses without the need for earned income. The influential Trinity study resulted in a WR of 4% (or assets equaling 25 times annual expenses) being commonly used as a rule of thumb for retirement planning. Because inflation and investment returns are unknown, there is no amount of assets that can guarantee financial independence, though assuming a lower withdrawal rate makes the portfolio more robust to extended periods of low or negative returns as determined by stochastic simulations or backtesting with historical data. The determination of appropriate withdrawal rate assumptions is a focus of ongoing research.[14]

Approaches to financial independence[edit]

Since there are two sides to the assets and expenses equation, there are two main directions one can focus their energy: accumulating assets or reducing their expenses.

Asset accumulation[edit]

Accumulating assets can focus one or both of these approaches:

  • Gather revenue-generating assets until the generated revenue surpasses living/liability expenses.
  • Gather enough liquid assets to then sustain all future living/liability expenses.

Expense reduction[edit]

Another approach to financial independence is to reduce regular expenses while accumulating assets, to reduce the amount of assets required for financial independence. This can be done by focusing on simple living, or other strategies to reduce expenses.[12][15]

  • Cut your fixed expenses wherever possible. (E.g., keep your internet service but discontinue cable; lower your phone plan type if you don't use all its features, etc.)

Examples[edit]

If someone receives $5000 in dividends from stocks they own, but their expenses total $4000, they can live on their dividend income because it pays for all their expenses to live (with some left over). Under these circumstances, a person is financially independent. A person's assets and liabilities are an important factor in determining if they have achieved financial independence. An asset is anything of value that can be readily turned into cash (liquidated) if a person has to pay debt, whereas a liability is a responsibility to provide compensation. (Homes and automobiles with no liens or mortgages are common assets.)

Age and existing wealth or current salary don't matter - if someone can generate enough income to meet their needs from sources other than their primary occupation, they have achieved financial independence. If a 25-year-old has $100 in expenses per month, and assets that generate $101 or more per month, they have achieved financial independence, and they are now free to spend their time doing the thing they enjoy without needing to work a regular job to pay their bills. If, on the other hand, a 50-year-old earns $1,000,000 a month but has expenses that equal more than that per month, they are not financially independent because they still have to earn the difference each month just to make all their payments. However, the effects of inflation must be considered. If a person needs $100/month for living expenses today, they will need $105/month next year and $110.25/month the following year to support the same lifestyle, assuming a 5% annual inflation rate. Therefore, if the person in the above example obtains their passive income from a perpetuity, there will be a time when they lose their financial independence because of inflation.

There are many strategies to achieve financial independence, each with their own benefits and drawbacks. To achieve financial independence, it will be helpful if you have a financial plan and budget, so you know what money is coming in and going out, have a clear view of your current incomes and expenses, and can identify and choose appropriate strategies to move towards your financial goals. A financial plan addresses every aspect of your finances.[16]

Passive sources of income to achieve financial independence[edit]

The following is a non-exhaustive list of sources of passive income which potentially yields financial independence.

References[edit]

  1. ^ Cummuta, John. "The Myths & Realities of Achieving Financial Independence Archived 2011-07-14 at the Wayback Machine.". Nightingale Conant. Retrieved on 14-Sep-2009
  2. ^ "43 Best Passive Income Streams & Opportunities | Income Ideas". Real Passive Income Ideas. Retrieved 2017-10-16.
  3. ^ "What is FINANCIALLY INDEPENDENT? definition of FINANCIALLY INDEPENDENT (Black's Law Dictionary)". The Law Dictionary. 2012-10-19. Retrieved 2018-10-31.
  4. ^ "Summary". 2011-01-25. Retrieved 2018-10-31.
  5. ^ "Your Money or Your Life". Mr. Money Mustache. 2012-12-19. Retrieved 2018-10-31.
  6. ^ Elkins, Kathleen (2018-03-08). "Millennial millionaires agree everyone should read this personal finance classic". CNBC. Retrieved 2018-10-31.
  7. ^ "Your Money? Or Your Life?". Afford Anything. 2018-04-09. Retrieved 2018-10-31.
  8. ^ "Your Money or Your Life - An Interview with Author Vicki Robin | Mad Fientist". www.madfientist.com. Retrieved 2018-10-31.
  9. ^ "163-The Impact of Your Savings Rate on Your Time to Financial Independence (A Tribute to the Value of "The Shockingly Simple Math Behind Early Retirement") - The Radical Personal Finance Podcast". The Radical Personal Finance Podcast. 2015-03-04. Retrieved 2018-10-31.
  10. ^ "Cover Story: Achieving financial independence early". The Edge Markets. 2018-09-07. Retrieved 2018-10-31.
  11. ^ "The Shockingly Simple Math Behind Early Retirement". Mr. Money Mustache. 2012-01-13. Retrieved 2018-10-31.
  12. ^ a b Your Money Or Your Life: 9 Steps to Transforming Your Relationship With Money And Achieving Financial Independence.
  13. ^ Eisenberg, Lee (December 26, 2006). "The Number: What Do You Need for the Rest of Your Life and What Will It Cost?". Free Press. ISBN 978-0743270328.
  14. ^ EarlyRetirementNow, Ern (March 11, 2017). "Safe Withdrawal Rates: A Guide for Early Retirees". SSRN. Retrieved 2018-11-25.
  15. ^ Early Retirement Extreme: A philosophical and practical guide to financial independence.
  16. ^ "What your financial plan should cover | Financial planning | GetSmarterAboutMoney.ca". GetSmarterAboutMoney.ca. Retrieved 2017-10-16.

Further reading[edit]

  • Vicki Robin and Joe Dominguez (1992) Your Money or Your Life, Viking. Your Money or Your Life: Revised and Updated for the 21st Century, published by Penguin Books in December 2008 by Vicki Robin with Monique Tilford and contributor Mark Zaifman.
  • Jacob Lund Fisker (2010) Early Retirement Extreme: A philosophical and practical guide to financial independence, ISBN 978-1453601211

See also[edit]