By Dr. James M. Dahle, WCI Founder
Most financially astute physicians have a goal of becoming financially independent at some point in their lives. Today, let's talk about whether you're moving toward FI or away from it.
What Is Financial Independence?
Financial independence can be defined as having enough income that you can pay for your expenses for the rest of your life without ever needing to “work” again for money. The financially independent may still continue to work but could live and support their family off of savings and completely passive income sources.
The formula for financial independence is relatively simple:
Financial Independence = 25x (Annual Spending – Annual Guaranteed Income)
You take how much you spend on a yearly basis, subtract the amount of guaranteed income you have, and then multiply the rest by about 25 (since the 4% rule of thumb suggests you can spend about 4% of your portfolio each year and expect it to last indefinitely). If your portfolio is larger than 25 times the difference between your spending and your guaranteed income: congratulations, you are financially independent!
3 Situations That Move Us Away from Financial Independence
The usual direction of our financial lives is to move gradually toward financial independence. However, there are three situations where we may find ourselves moving away from financial independence.
#1 Portfolio Loss
The first is rather obvious—when the size of our portfolio falls. This may be due to spending a bunch of it but may also be due to market losses, divorce, inflation, confiscation (government or a creditor), or devastation. If your portfolio was $1 million last year and it is now $500,000, you are probably further from financial independence than you were a year ago.
#2 Loss of Income
The second situation is where something happens to your guaranteed income. Obviously, some guarantees are stronger than others. Your Social Security or pension income could go down with the death of a spouse. Income from an annuity could decrease in the event of an insurance company going under, although that may be backed up to some degree by a state guaranty association. Income sources that you thought were guaranteed but really aren’t, like real estate rents, can also fluctuate significantly. Like with a decrease in portfolio size, this situation is also generally readily apparent.
#3 Increase in Spending
However, the third situation in which we become less financially independent is far more insidious. This occurs when our spending goes up due to lifestyle creep. It is a rare physician that hasn’t experienced lifestyle creep at some point in their life, most notably upon leaving residency when most new graduates succumb to a lifestyle explosion as their income quadruples. However, even a careful physician who lives like a resident for 2-5 years after residency to stabilize the rest of their financial life can still be caught out unknowingly later in their career. What most don’t realize is that even a millionaire’s portfolio cannot keep up with even a moderate rate of lifestyle creep.
An Example of Becoming Less Financially Independent
Consider a physician with a $2 million portfolio and no guaranteed income. They are spending $10,000 per month or $120,000 per year. Therefore, financial independence for this doctor is a number of approximately $3 million, and the gap between what they have and what they need is $1 million. Let’s assume that their portfolio made 6% this year ($120,000) and that they added another $100,000 in new savings. At the end of the year, their portfolio would be worth $2.2 million. Surely they would be closer to financial independence than they were a year ago, right? Not so fast.
If they also increased their spending by 20%, from $10,000 per month to $12,000 per month, then their financial independence number also went up by 20% and is now $3.6 million. Despite a portfolio that increased by over 10%, they are now even FURTHER from financial independence, since the gap increased from $1 million to $1.38 million. At this rate of lifestyle increase, they are unlikely to EVER reach financial independence no matter how well their portfolio does or how much they save.
However, if the increase in spending is a one-time increase, then they have merely delayed the date at which they reach financial independence (from four years to six years), not put it off forever. Obviously, the math also works in reverse. If you can cut spending (such as by paying off your mortgage), you can shorten the time to financial independence.
The other consideration when increasing spending, of course, is whether the purchase is a “one-time” purchase or an ongoing expense. For our example physician, spending $10,000 on a very nice trip to Europe would have very little effect on the financial independence date, unless it becomes an annual event. However, too many high-income professionals mistake an expensive one-time purchase for what is actually a habit of purchasing something expensive every year. It might be a boat one year, a new car another year, and a major home remodel the third year. It might feel like these are all one-time events, but in reality, it is a new, higher level of spending that will, at a minimum, delay financial independence significantly.
So what is the solution for a doctor who wants to enjoy all that life has to offer but who also wishes to reach financial independence well before the traditional retirement age? Like with most of your financial life, the solution is multi-factorial.
How to Achieve Financial Independence AND Enjoy Life
While becoming financially independent is no small feat, consider these five factors to make financial independence easier as you enjoy life in the meantime.
#1 Front-Load Your Retirement Savings
Getting a big chunk of your nest egg in place relatively early in your career gets you in the habit of saving while the growth on that portfolio also decreases the effect of later lifestyle inflation on the financial independence date.
#2 Put Your Money Where Your Values Are
What I care about most
As a doctor, you have enough income to do anything you want but not everything you want. You cannot spend nearly as much of your high income as you imagine due to the progressive tax structure, usual student loan burden, and high savings rate required to maintain your lifestyle in retirement. Prioritize what matters most to you and follow a written spending plan of some type to ensure you’re spending on what you care most about. If you don't have a plan yet, we have an online course specifically designed to help you cheaply and quickly get one in place.
#3 Keep Fixed Expenses Low
Fixed expenses generally have a greater effect on your financial independence date than variable expenses, so minimize them as much as possible. You can do so by purchasing a smaller house, having a larger down payment, using a 15-year mortgage, paying off your student loans rapidly, living close to your place of employment, and purchasing with cash whenever possible (which should be almost always as a high-income professional).
#4 Use Extreme Caution When Increasing Spending
When you do decide to spend more, approach this decision with the serious caution it deserves. Weigh the joy you will get from the spending with the increased amount of time (and possibly work) required to reach financial independence. Honestly assess whether the increased spending is a one-time purchase or an ongoing commitment. Also consider whether a one-time purchase will increase your fixed expenses (insurance and maintenance for items such as a second home, an expensive auto, or a recreational vehicle).
#5 Protect Your Portfolio and Guaranteed Income
Invest in a reasonable manner, purchase appropriate insurance against financial catastrophes, and prioritize your marriage. Consider increasing your guaranteed income through the purchase of Single Premium Immediate Annuities (SPIAs), but keep annuity amounts below the state guaranty association limits.
Financial independence can be a moving target, particularly for those who inadvertently increase their ongoing spending commitments. Following these tips will help you to enjoy as much of your high income as you reasonably can without committing you to stay in the “rat race” any longer than you wish.
What do you think? Are you moving toward or away from financial independence? When was the last time you moved away? Why was that? Have you ever monitored this? Comment below!
[Editor's Note: This post was originally published as one of my monthly columns in MDMagazine.]
Great article and I’m sure something that happens quite frequently to physicians.
We’ve noticed this phenomenon ourselves recently. Started out living like residents in early attendinghood and before you know it, the expenses (some fixed, some one-time) really start skyrocketing: engagement ring, vacations, new cars, new home, wedding, honeymoon, new baby, etc
I see the third situation a lot with the high income folks I work with. The new car, second house, fancy vacations-and yet some can’t put enough in the 401k to get the full match (6% of pay). I’m worried about what’s going to happen to those folks when they want to retire or cut back on work. Their “FI number” will be high to maintain their lifestyle (which increases every year), yet their savings will be low.
It’s easy to forget that even if your savings amounts increase due to a pay raise, if you inflate your expenses you may end up further away from FI due to the increase in assets to support those expenses. Sure you could reduce those expenses later, but it’s hard to cut back once you live a certain way. Great subtle concept.
“(since the 4% rule of thumb suggests you can spend about 4% of your portfolio each year and expect it to last indefinitely)”
30 years doesn’t seem indefinite to me. Are you showing your youth, WCI, in your concept of indefinite?
Remember that on average in the Trinity Study, after 30 years you have 2.7X what you started with. Most of the time, 4% is indefinite. It’s only when bad returns show up early (sequence of returns risk) that the possibility of dying with less than you started with comes into play, much less running out of money.
You guys are so literal. I find the uncertainty of the term part of the Trinity study and the uncertainty of our time frames to be the most interesting part of this rule of thumb. Sorry for going a little existential on you!
Tone is always hard to judge on the internet.
I’m the same age as Dr. Dahle, so I can field this one. The average outcome when using a 4% SWR for 30 years is to have your portfolio increase to 2.8x its original size.
It is true that you’ve got a better chance of not spending down to zero over 30 years compared to 60 years, but the longer timeframe also has a better likelihood of making you very wealthy. “Big ERN” has done a nice examination of SWR at various percentage drawdowns. Part 2 has tables showing success of likelihood.
https://earlyretirementnow.com/2016/12/14/the-ultimate-guide-to-safe-withdrawal-rates-part-2-capital-preservation-vs-capital-depletion/
Best,
-PoF
30 years seems like a blink of an eye to me?I encourage everyone to learn to track spending. If you do this it is easy to make a correction a long the way to FI.
A good thing to realize if you’re new to these calculations is that your monthly spending/expenses in retirement are likely to be dramatically less than they are while working. You can take off the retirement contributions, student loan payments, car payments, daycare payments, most insurance premiums, mortgage payments (hopefully). You get the picture. Ignore calculators that include assumptions that you will have anything near the level of expenses as you currently do.
Run the numbers yourself making sure to add in extra money for travel, further support of children, and health care expenses. Darrow Kirkpatrick’s book “Can I Retire Yet” is a fantastic place to start with this process even if you still have a ways to go.
And don’t forget reduction in the biggest expense of all: Taxes (Fed, social, medicare). We retire this summer to coordinate with DW’s replacement coming out of residency. Even with plans to convert substantial tax deferred accounts to Roths, we will never again see six figure Fed tax bills–and no payroll taxes. (We chose to refinance this fall and keep a mtg though… 2.75% and less than 1/10 of our planned retirement spending.)
I’m afraid that our expenses will increase substantially after retirement. (I don’t count savings as a current expense.) Health insurance is extremely expensive and future increases are likely to be high as well.
We currently pay a little over $4000 per year for my employer-sponsored plan, but a physician in our community (same age) told me yesterday that he tried to buy a plan through ACA and the quote was $25,000/year!
Part of your issue is you aren’t counting expenses you actually have right now. You might only be paying $4K, but your employer is probably paying another $10K, which is really part of your salary. So you actually have more income and more expenses right now than you think.
I don’t see how one can stop paying insurance. No house? No car? Forego healthcare?
Remember that the 4% rule has an implicit assumption that the worst financial downturn possible has already happened. That nothing worse is possible. But the worst event so far is always by definition that worst that has happened in the past. As soon as something worse comes along, the old “worst ever” becomes bad, but not the worst. There is no reason to assume that the worst in the last 120 years or so is the worst possible.
30 years retirement may be reasonable if one stops working at 65 or later, although living past 95 is certainly possible. Enough to cover 30 years of retirement is hardly sufficient for someone who quits at 50.
Need more than 30 years if retiring early. Of course, if you are forced to retire by poor health, your life expectancy may be much shorter than 30 years. In that case, less longevity to worry about.
The dreaded spending creep! It’s a silent killer…
I find that most people who have increasing incomes also increase their spending. That’s ok as long as you only spend a part of the increase — and save another part to help you on the path to FI.
The REALLY BIG problem is when someone starts to spend way more than their increases. At that point they are certainly moving away from FI.
The creep is real, even for those who think that they are conscientious about their spendings. I was only between the first and second year of my job when I started looking into crazy fancy vacations (we all have our sins) thinking that it’d be okay to splurge since it was “only one or two paychecks” (post-tax, mind you).
Even now that I’m trying to reign in the spendings, I have noticed that the growth rate of my net worth has slowed down. It sure felt good going from -$100,000 to +$50,000, but things already started slowing down after +$250,000!
Lifestyle creep everywhere, squash that bug!
I find we have one time expenses, 9-10 months out of 12.
I have sort of given up, just make sure I am maximizing IRAs, and saving a chunk in taxable automatically every month. Live paycheck to paycheck after that (not so dire as I make it sound).
My next goal really is to pay off my house.
Interesting! I find that in my mid forties I spend and need less than five years ago. The killers for me are rent (I live in a lovely but overpriced area and am reticent to buy) and health insurance, over which I have no control. Alas, lifestyle creep isn’t an issue for me, but the bloated real estate and health insurance markers are!
Even now that I’m trying to reign in the spendings, I have noticed that the growth rate of my net worth has slowed down. It sure felt good going from -$100,000 to +$50,000, but things already started slowing down after
Now we are FIREd and seem just fine I want to let DH (dear, still, husband) live a little larger. However the supposed one offs come with clear or likely higher monthly costs. The bigger boat costs a bit more to insure, longer slip fees, diver HAS to bottom scrape monthly, etc. and who knows what every few years maintenance is needed or what the cost will be. And inflation for all of that. Now the ordered sports car will get moldy in our humid garage. Him cleaning the garage was free, running a fan or dehumidifier won’t be, and while my solution- DRIVE IT frequently- is obvious, just visited the kid who has his older much cheaper sports car and boy is premium expensive! Think this is his last “one off” splurge. Time to educate him and myself about insidious lifestyle creep like this.
Yeah…doing an ok job first 10-15 years out with lifestyle creep isn’t enough…it was easy because of home and car were bought relatively cheap…but each of these are being upgraded now and the Creep is becoming a supersonic burst…It can be easier in some ways to keep it in check when we first start working…but after getting to an ok place it’s easy to rationalize some bigger purchases, more expensive vacations, etc later in life….I’m kind of doing the opposite of some….not great…rule of thumb of saving more than we spend is ok…more difficult to do now….but I wonder even when doing that does that make up for the ‘ creep ‘….or like I said ‘ run ‘ that’s happened to me….sorry for rambling…but in essence…if you can figure out a way to save more than you spend…regardless of life style creep….is that enough?
Just saving more than you spend isn’t enough. Docs should really be aiming to put 20% of gross away for retirement.
We find our spending has been going down for years.
We have tried enough to know that expensive stuff is not something we want. We now spend less on travel (never out of the country, usually only a short drive from home), on dining (we don’t like expensive restaurants), on clothing (thrift shops and ebay), gifts among ourselves- we have what we want.
Call it inverse lifestyle creep.
AFAN – sounds like you are describing Contentment, which seems like the perfect antidote to lifestyle creep!