Achieving Greater Financial Freedom – Why We Do Want It and What Does It Mean

This blog is not going to be solely (or even predominantly) about financial independence and early retirement.

However, as described in my second post, one of the Cavalier clan’s key objectives is achieving greater financial freedom and the financial independence movement is one of the inspirations for this blog. Therefore, in some upcoming posts I’ll:

• describe what I mean by financial freedom and why we’re seeking to achieve it.
• explain how the Cavalier clan is planning to achieve financial freedom.
• look at the relationship between financial freedom and our other objectives, and what types of trade-offs this could involve.
• discuss some of the books, blogs and other resources that we’re using to help inform our journey.

What do I mean by financial freedom and why do we want it?

Essentially, what I mean by financial freedom is having the option of not needing to work in a salaried job.

We don’t want this option so we can bum around searching Youtube for footage of Geelong games from the mid 80s when Gary Ablett, Michael Turner and Greg Williams were all part of the same centre line (hang on, Mrs Laughing Cavalier busted me doing that this morning). Rather, Mrs Laughing Cavalier and I want be useful, productive members of society for as long as we can, but we want flexibility and autonomy as to the form this takes.

For example, we’d like to have the flexibility to:

• Work together on joint projects (we’ll talk a bit our garden projects in future posts).
• Build new skills together and use them in our joint endeavours.
• Have the time and space to recharge and avoid excessive mental clutter.
• Devote more time and energy to community activities.

We may even want to continue working in salaried jobs after we obtain financial freedom if this is fulfilling and rewarding (and I suspect that financial freedom will bring with it greater confidence, honesty and willingness to take risks that would make us better at our jobs), but we want the option of doing something else if it’s going to be more fulfilling.

So, when will we have financial freedom?

The 4% rule (at an oversimplified level)

Not surprisingly, Mrs Laughing Cavalier and I aren’t the only people asking this question.

A widely used rule of thumb used to to answer this question known as the 4% rule.

At a highly oversimplified level, the 4% rule provides that it should be safe for you to spend 4% per annum of your invested savings (ie. spend 4% in the initial year and then continue to spend 4% indexed to inflation in subsequent years). To put it another way, you’re invested savings need to be 25 times your annual spending (eg. if your annual spending is $40,000 you’d need to have savings of $1 million).

Influence of the 4% rule – it’s what you spend that is critical to financial freedom

The 4% rule is highly influential – see how many hits you get on a Google search.

It’s particularly influential in the financial independence/retire early movement in Australia and internationally, and is described, analysed and/or applied by a number of bloggers in this space (eg. see The FI Explorer, Enough Time To and Mr Money Mustache).

I think there are a few reasons for this influence.

Firstly, as described further below, it has a sound theoretical origin.

Secondly, having a specific target or goal provides motivation and focus.

Finally, the really powerful insight that the 4% rule provides is that the most critical determinant of financial freedom is how much you spend as this the number being multiplied by 25. That is, minimising your spending is generally going to be much more important to obtaining financial freedom than increasing your earnings (although, this obviously helps).

Where does the 4% rule come from?

The origin of the 4% rule is an article written by William Bengen, a US financial adviser, in the Journal of Financial Planning in 1994 (for anyone under the age of 30 who may be confused by the hairstyle in the photo, it’s what was known as a comb over). The article sets out Mr Bengen’s analysis, based on historical US market data, of the likelihood of exhausting an investment portfolio (ie. the likelihood of the people with the investment portfolio being up s*it creek) under a range scenarios incorporating:

• different timeframes ranging up to 50 years
• different withdrawal levels (ie. what is the percentage of the portfolio being withdrawn each year, assuming that the initial withdrawal is indexed to inflation in each subsequent year)
• different asset allocations (ie. the proportion of shares and bonds in the investment portfolio)

One finding from this analysis was that, with an asset mix of 50% shares and 50% bonds, there is very low risk of the portfolio exhausting within 35 years at a 4% withdrawal level (and, in almost all scenarios, the portfolio would last at least 50 years). Hence, the 4% rule.

In 1998, three professors of finance from Trinity University undertook a similar analysis delivering similar results which was set out in a paper that widely referred to as the Trinity study. This study was updated in 2009 and the outcomes are well summarised here in the jlcollinsnh Simple Path to Wealth blog.

Does the 4% rule work in Australia?

Coming from an Australian perspective (or, in fact, any non-US perspective) a fairly obvious problem in relying on these studies is that they’re based on US market data.

Fortunately, this gap has started to be filled in recent years through studies analysing safe withdrawal rates in Australia and other jurisdictions. For example:

• This study commissioned by the Financial Services Institute of Australia (FINSIA) analysing safe withdrawal rates based on market data from Australia, New Zealand, Italy, Japan and the Netherlands.
• This article in Morningstar, which incorporates into its analysis of safe withdrawal rates an assumed 1% fee for managing the investment portfolio, projections of future returns (which are assumed to be lower than historic returns) and investment portfolios including a range of Australian and international assets.

In brief, these analyses are more conservative than the Bengen and Trinity studies. In fact, the Morningstar analysis concludes that the lower end of the range for a “safe” withdrawal rate is 2.5% (ie. your savings would need to be 40 times your annual spending).

I’ll talk a bit about how Mrs Laughing Cavalier and I are approaching the how much is enough question below, but a couple of specific observations about these bits of analysis:

• Informing Mrs Laughing Cavalier that I’ve gone all in on Italy is going to be a difficult conversation (anyone who read the FINSIA study will be pissing themselves at this point, or possibly not).
• My sense is that the Morningstar analysis is too conservative. In particular, the 1% portfolio management fee assumption is problematic for a couple of reasons:
  • Your portfolio management fees are part of your spending. That is, they should be seen as part of the quantum of money you’re withdrawing from your portfolio each year, not as a distinct item.
  • Spending 1% per annum of your investment portfolio on management fees is excessive and unnecessary – this will be discussed in future posts
• Also, while I’m probably inclined to agree with the view that it’s more likely that future returns will be lower than historic returns (a bit of the Morose Over Analyser creeping in here), the reality is predictions about the future are almost invariably wrong.

Are we going to use the 4% rule?

The short answer is yes for present purposes. This is principally for the reasons I outlined above about why it’s become so influential in the financial independence movement:

• It gives us target to work towards. I’d endorse the comment in the FINSIA study that the 4% rule remains a very useful mental shortcut.
• It does have a theoretical basis (even if the precise number is likely to remain the subject of debate).
• It chrystallises the importance of making considered and deliberative choices about our spending.

Are we worried about the 4% rule being wrong, particularly in light of recent Australian studies, and ending up destitute because we relied on it and retire too early? Not really. This is mainly because, in reality, we wouldn’t be blindly applying the rule and would be adapting our behaviour if there was a genuine risk that our savings would run down. For example:

• Adjusting our levels of spending. Remember, the 4% rule assumes you spend 4% of your portfolio in the first year and then continue to spend that amount (indexed to inflation) for the rest of your life. In reality, we would adjust our spending levels if our portfolio was running down.
• Undertaking paid work – one of the reasons we want the option of retiring early is so we have the opportunity to develop new skills.
• Ultimately, having the option of accessing social security.

Another reason to be relatively sanguine about the 4% rule is that the definition of a “safe” withdrawal rate in the studies I’ve referenced tend to be very safe. For example, even with the more conservative Morningstar approach, if you had a portfolio that was 70% shares and 30% bonds and your retirement period was 40 years:

• You’d have a 95% chance of success at a 2.5% withdrawal rate.
• You’d have an 80% chance of success at a 3.3% withdrawal rate.
• You’d have a 70% chance of success at a 3.7% withdrawal rate.

To put it in context, would you deprive yourself of several years of financial freedom to increase the probability that you could safely withdraw a certain level of money each year from high to almost certain? Alternatively, would you rather obtain financial freedom significantly earlier in your life, recognising that you may need to make the type of adjustments described above if investment returns aren’t working out as hoped.

We’ll continue to keep a watch on this issue and, as we get closer to the point that we could have financial freedom, the depth of analysis in Australia will hopefully have progressed further. There may even be an Australian version of a tool like this one from Vanguard which is available for US investors and provides probabilities of how long savings will last under different scenarios (this is really cool).

In future posts we’ll be talking more about how we’re trying to get financial freedom.