(Photo: Steve Buissinne via Pixabay.)
What is the goal of this quest for financial independence? I want to generate enough passive income to sustain a sufficient standard of living so that exchanging my life time for money becomes an optional, rather than required, endeavour. Last time we talked about how to calculate the pot size, the advantage of compound interest and the difference between nominal and real return.
This laid the foundation to determine an exit strategy from work life. Today, let’s optimise this a little bit; get better estimates for annual expenses, pot size needed and the path to get there. As a heads-up, the numbers I use in this post are arbitrary; they do not represent my spending, nor do I expect them to represent yours. Take them as example and plug in your own requirements.
How much money do I need?
Let’s revisit this: How much money do I need in a year to live? The yearly spending pot needs to cover obvious expenses like housing, levvied taxes, food and transportation. It needs to cover household expenses like replacing broken dishes, buying clothes. Gifts for friends and family, your hobbies. Medical expenses (NI, dental spending), shelter and transportation maintenance. And unexpected spending, e.g. when you’re invited to a surprising amount of weddings and silver anniversaries. As key component in retirement planning, getting these numbers right is critical. And as with many things, data is king. There are several approaches to figure out how much money is needed to sustain a given lifestyle; with varying levels of effort involved.
Annual salary vs. savings account
Easiest is probably to just to look at your net income and check how much money is left at the end of the month. Multiply by 12, or check the last year’s bank statements, and you have a good quick number for your annual spending and your savings rate. As Mr. Money Moustache showed in his (in?)famous post, with just those two numbers you can already calculate a rough time-to-FI. For example:
This table makes several assumptions:
- You achieve an average real yearly return of 5%.
- You are happy with a 4% safe withdrawal rate.
- You will not touch the principal and live off capital gains and dividends.
- You will spend as much money in financial independence as you spend now.
And that is all you need to get started!
There are caveats that come with these assumptions, but they work for a rough feasibility check of your financial plan. Especially the last point is debatable: If you want to have a luxurious lifestyle living in fancy hotels, your expenses will likely be higher. But statistically, people spend less in their retirement than in their working days – no daily Pret and Starbucks, no commute, no suits to keep in shape and style. And often no mortgage to pay anymore.
Therefor option two: Bucketise your spending. Tabulate how much money you are spending in several, obvious and nonobvious, categories:
|Rent / mortgage||£1,200.00||Monthly||£14,400.00|
If it helps, separate costs for work-related activities from private activities. Look at what you pay daily, weekly, monthly, quarterly, yearly. For your current spending, the number should be fairly close to the number you get form checking pay slips vs. savings increases. Because both is based on the same data, obviously.
This particular bucketised list shows annual spending of £41.400; going by the 4% SFW rule, your target pot size for financial independence is £1,065,000 (yes, a tad over a million pounds). That’ll take a moment to amass.
However what the buckets now allow us to do is twofold:
- Identify categories of high spending, as well as
- identify categories that will change once leaving the workforce behind.
Both helps with finding ways to reduce the yearly spending. In the above example, rent is the largest factor with about £14,000, followed by the groceries category at £6,000. The rent is exemplary for a central London 1 bedroom apartment or a south London 2 bedroom apartment. With it being the largest category, it is the most obvious starting point for consideration. London is great, but retiring outside Zone 6 can literally shave years off the mandatory work period. Or why not retire in a drier, warmer country? Even considering current currency fluctuations, there are quite affordable warm places to live in without compromising lifestyle quality. Dropping monthly rent by half to £600 reduces the required portfolio size by £180,000! Which gets you a pretty decent sized flat in a nice part of Malaysia (for example) and drops the pot size to £885,000. Already below the million mark!
Pull a Mr. Money Moustache and lose the car, save another £380 per month – and another £66,000 from your target pot size (now: £819.000). A bicycle is a surprisingly effective mode of transport, especially with a well-selected flat location after retirement.
By the way, being retired means: No work lunches anymore! Drop another £2,920 off the annual budget, and the target pot by £73.000 size to £746.000.
It is easy to see that there is plenty of optimisation potential in a London professional worker’s budget to save money in retirement; without giving up the occasional latte or the nights out with the mates.
Track weekly/monthly spending
For an even better estimate, data is king: Collect your receipes and track your spending. This sounds a lot more daunting than it is; spend an hour at the end of a month summing your spendings up in a spreadsheet is all it takes. And of course there are tools to help you. From pre-made budgeting spreadsheet templates (e.g. the personal annual budget template in google sheets) to software bespoke to just this purpose. I recommend You Need A Budget; it has excellent “bucketising” and tracking capabilities, and is highly flexibly in sorting, renaming, administering of your notes (caveat: my experience is mostly with the classic version).
Comparing the buckets of path 2 with the quick earning-vs-saving path 1 likely yields a difference; what your buckets say you spend vs. what you actually spend is unlikely to match up – the buckets are estimates, after all. Tracking it for a year (12 times, once per month, is all that’s needed) gives a lot clearer picture of your spending. I found analysing my spending quite fascinating. There are, obviously, diminishing returns to tracking spending for more than a year, so your mileage on this method may vary, but seeing it “in print” helped understanding where the money went. Where it really went, not where I thought it went. For example, understand just how much money I spent on my motorcycle, past the £3,000 I paid for the bike itself. The true cost of ownership, the TCO. Licence, gear, fuel costs, small trinkets – it adds up surprisingly fast …
This method giving me a real, evidence-supported itemisation of my spending certainly gave me confidence in my planning for the future. Confidence to know that this number at the bottom is the maximum amount of funds I will need in retirement (as my current lifestyle gives me all I need and desire). It can only get better from there!
Therefore, all in all, I heartily recommend going through this process even if you don’t hunt for early retirement. If you wish to have more money in your life, finding out where the money goes is an enlightening step. Sometimes the truth hurts, but it always liberates.
— The Adventurer