Your Path to Financial Independence

Published on: 27 Dec 2023

In this post, we will simulate multiple scenarios when planning to achieve financial freedom. Learn how to use the app for planning your retirement or financial independence

Written by The Interactive Finance

This post explains how to use the financial planning app and simulates some scenarios with a few interesting outcomes.

Brace yourself for an insightful journey ahead – it’s going to be a comprehensive exploration. So, grab your favorite drink and savor the knowledge unfolding before you.

Financial Independence

Achieving financial independence is a worthy goal that provides security, flexibility, and options by generating enough passive income streams to cover living expenses. However, many struggle with charting a clear path to reach this destination.

Let’s try to understand why one must plan for financial freedom or financial independence, two terms often used interchangeably to denote the same objective.

Financial freedom hedges against uncertainty - loss of earned income unexpectedly can lead to significant lifestyle disruption without adequate savings and investments. Building alternate income sources creates stability and peace of mind.

Additionally, financial independence provides more control over how one’s time is spent by potentially funding desired activities beyond traditional employment.

The high-level premise is simple - consistently saving and investing a portion of regular earned income can ultimately compound into a sizeable nest egg that spins off its cash flow.

Some of the scenarios enabled by achieving sufficient cash flow outside of traditional employment include:

• Generating money with minimal ongoing active efforts.
• Covering lifestyle costs with investment income rather than salary.
• Pursuing passion projects or new careers.
• Retiring early from full-time work while still funding desired lifestyle

The Variables

Now, you might be pondering how to kick off this journey — questions about how much to save, where to invest, expected returns, handling inflation, and setting a target amount might be swirling in your mind. Fear not, we’ll tackle each of these aspects one step at a time.

Income Expenses and Investment

The first step is to allocate a certain percentage of monthly income to investment after accounting for expenses.The higher you save, the earlier you will reach your goals.

We assume that income will increase at a fixed rate annually and as income increases expenses and investment will also increase in the same proportion. This is indeed a simplistic assumption to make our calculations less complex. Over a long period, the yearly variations smooth out and results may not differ much.

Current Networth

Your current net worth should already be generating some income. Identify the assets that can help you generate further income.

• Exclude the value of the primary house and depreciating assets like vehicles, appliances, etc.
• Exclude any amount needed in the short-term
• Assets can include current investments in bank deposits, bonds, stocks, mutual funds, land, - secondary property, etc

Target Amount

When setting a savings target for financial independence, it is helpful to frame it in terms of yearly living expenses. This creates an “expenses multiple” target that considers how many years current spending could be covered by the accumulated assets.

We express this as:

For example, if your current yearly expenses are INR 12L and you choose years of expenses as 25 then your target amount is 25*12L = 3Cr.

This also means first-year withdrawal rate is 4% (of 3Cr) which is the amount needed in the first year of retirement.

The key is to pick a suitable number for years of expenses which would translate to a safe withdrawal rate.

Basing financial independence targets on annual spending provides inherent flexibility for the future. Even with evolving life stages and rising costs over time, the same expenses multiple formula can be applied. All we need to do is calculate the future expenses which again is based on income which would keep up with inflation.

Inflation and Returns (Annual)

Annual inflation and expected returns are related to each other. We use these values to calculate the cost of living and expected returns on your investments

While you’re earning, salary increases cover inflation, using a fixed percentage for yearly expenses. In retirement, inflation is used to calculate living costs.

The expected return on investments depends on the inflation rate.

In the financial planning app, pick a risk profile, and it’ll automatically calculate returns based on inflation and your risk level. However, you can change the return value if you feel you need more flexibility.

There are three options, you can choose for risk profile.

1. Low Risk: Returns match inflation. Options: bonds, fixed deposits, govt schemes, debt mutual funds.
2. Medium Risk: Returns 3-5% above inflation. A mix of debt and equity investments.
3. High-Risk: Returns 5-7% above inflation. Mainly equity, with at least 80% in stocks or equity mutual funds.

We use this formula as this is somewhat universal and applicable in most of the world.

You can choose different risk profiles during pre-retirement years and post-retirement. During pre-retirement years you can take more risk and during post-retirement, you can choose a lower-risk profile.

You can use the chart below to understand the long-term inflation rates and stock market index returns.

• Currently stock market index returns are available for India and United States.
• The market returns are price return .
• For India, as of 2022 the data for the last 40 years shows:
  • Annual Inflation rate is 7.38%.
  • BSE Sensex returned 14.89% CAGR.
  • BSE Sensex returned 7.51% above the inflation rate.
• For United State , as of 2022 the data for the last 60 years shows:
  • Annual Inflation rate is 3.85%.
  • S&P 500 returned 7.09% CAGR.
  • S&P 500 returned 3.24% above the inflation rate.

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The Financial Planning App

We will use the financial planning app to demonstrate few scenarios.

When you launch the app, it will have all data pre-populated and by default, the app will cover the first scenario.

Start Early to Retire Early

Starting your career? Here’s the plan: save a lot, and take some big risks, all to retire early. Imagine saying goodbye to work sooner than you’d think! That’s the goal.

We will use the data in the table below to simulate the results.

Some observations on the inputs and results.

• Striving for early Financial Independence, Retire Early (FIRE) with a 60% income savings rate.
• 30 years of expenses is required to ensure funds last for a long time after early retirement.
• Post-retirement, adopting a medium-risk investment profile to outpace inflation.
• Simulation results forecast achieving financial freedom by age 40.
• Post-retirement funds are projected to last beyond 90 years of age.
• Even though it looks like net worth is still increasing after age 90, years of expenses is decreasing ( withdrawal rate is increasing). Amount would not last beyond a few years

It’s Never Too Late To Start

Let’s consider someone aged 40, accumulated some money but does not have a financial plan yet. They never thought about it but are keen to start it. They may not aspire to retire early but want to secure their retirement beyond the traditional retirement age of 60.

• This person would like to continue working till the age of 60 so we don’t need to set any target Years of expenses. Instead, we rely on other parameters to maximize the target amount. But our simulation needs it as input so we put a sufficiently high number of 50.
• The algorithm will run the calculation for the target amount till 60 years of age and if the target is not reached it will start the post-retirement calculation from whatever amount is calculated.
• The results show that by the age of 60, the amount equal to 21 years of expenses is accumulated, which is sufficient to last for 90 years of age.
• It’s no surprise that delaying retirement requires less funds in terms of years of expenses, provided investment returns are the same.
• We choose the Risk profile: Retirement as medium so that money lasts till age 90, if we choose it as low, then we need more years of expenses.

Eternal Prosperity

Humans have finite life but wealth can last forever. That is how generational wealth gets created. The idea is that if your investment income outpaces the expenses, the money keeps growing and can be passed to the next generation and the cycle repeats. Another way to see this is if your withdrawal rate keeps decreasing your income and net worth will keep on increasing.

It sounds too good, and may not be easy to achieve but possible. Let’s break down what would it take to achieve this.

This is a slight variation of first scenario Start Early to Retire Early with one key difference.

• Post-retirement we continue with High-Risk investments yielding 13% per annum instead of Medium risk yielding 10%
• This single factor of 3 percent more annualized returns, is strong enough to generate long-lasting wealth.
• The accumulated worth in terms of Years of Expense keeps on increasing, and the withdrawal rate decreases after retirement
• At the age of 90, this method yields 218 years of expenses which are adjusted for inflation.

The risk threshold is higher no doubt and this strategy may backfire in case of some black swan events, so having a good risk mitigation strategy is important.

Concluding Remarks

When modeling investment returns, it is prudent to make conservative assumptions instead of overly optimistic projections.Even a single percent variation in investment yield can substantially impact long-term returns.

However, it’s essential not to blindly trust information, and the mantra should be “trust but verify”. I have personally applied these calculations throughout my investment journey, which spans over a decade and a half. From my experience, I can affirm that this approach and calculations hold good.