Last week I met with a group of former U.S. Senators traveling to Beijing to meet with the Chinese government. Our discussion focused on the US-China commercial relationship and bilateral trade negotiations.

At one point I argued that the US trade deficit with China—of which reduction is a priority for president Trump—was a poor metric for measuring the health of the bilateral commercial relationship. Senator Heller agreed with me. He noted that Americans thrive from consuming low cost products produced by other countries, “we are a nation of consumers, and that’s not going to change.” 

He’s right. In 2018, personal consumption contributed 69 percent of U.S. GDP. Consumption of goods and services is essential to the economic health of the nation. But excessive consumption, or spending is the antithesis of financial independence.

Consumption in America

I am not advocating the end of American consumption. But there is room to trim discretionary spending. Take a look at 2017 spending by the average American consumer. 

Housing, transportation and food make up the lions share of American spending. Lets drill down on housing.

Housing as a proportion of American household spending has remained roughly static over the decades. However, the average square footage of the American home has increased while while family sizes have contracted. Today, the vast majority of new homes constructed in the U.S. are four bedrooms or larger.

Instead of living in a four bedroom house in the suburbs, imagine if the average American lived in a slightly smaller three bedroom home within biking distance of work.

Buying or renting smaller square footage would lower housing costs. Biking to work would reduce fuel costs. After relocating to an urban setting, groceries are easier to procure. Cooking at home becomes more convenient. By making that move, the top three categories see immediate reductions.

The average American savings rate

Every dollar spent on consumption is one less in savings. In March 2019, saving as a percentage of disposable personal income was 7.3 percent.

How long would it take one to retire at a yearly savings rate of 7.3 percent with a 5 percent annualized return? Take a look at the below.

55 working years. If a person entered the workforce at 21, by the ripe age of 76 he could retire with enough savings to maintain levels of spending to death.

The more you save, the earlier you reach financial independence. If you save 20 percent of your salary, you can achieve independence in 36 years. Save 50 percent, independence in 16 years. If you save 70 percent, financial independence comes in eight.

Now that we’ve set the stage, lets look at the rules.

(1) Save 25 times annual spending 

Simple. Save 25 times your annual spending—not income—and you are financially independent. MMM’spost offers an excellent overview that is worth a read, but what does the average person think they need to retire?

I was playing cards with a group of Americans this week and asked what their target number was for retirement. Going around the table, the answers were mixed. Some said a few million dollars, one suggested a fully paid off house was enough. One offered a thoughtful response, “the dollar amount doesn’t matter, what matters is how much you can live on and how long you need to maintain those savings.”

A financial independence adherent would would agree wholeheartedly with the last response. Financial independence is a function of three components, income, spending, and savings. If the average American is saving only 7 percent of income, it implies 93 percent is going to spending.

Ok, lets get the obvious out of the way first. Spending less means more is invested. Therefore, spending less also means reduced savings are needed to support the more frugal lifestyle. As income rises over time, for a FIRE adherent, the spending will remain constant. Continually widening the gap between income and spending will ensure a larger and larger percentage of income is going into savings while concurrently adjusting to a more modest lifestyle. 

Lets illustrate this with the average American income in 2017: $61,372.

Based on what we’ve established so far, the average American would save 7 percent of his salary. That implies spending is $57,075. To accumulate 25 times that amount ($1.4 million) at a 7 percent savings rate ($4,296) would take 55 years.

If that same American spent 40 percent of his salary it would total $24,548. To accumulate 25 times that amount ($613,700) Saving 60 percent of his salary ($36,823) would take 12.2 years.

This is the paradigm shift in thinking that attracted me to the financial independence movement. Reducing spending is much more impactful than increasing income. The returns are logarithmic.

Chad Carson’s book offers a helpful anecdote that illustrates this idea:

“When Louis was in his twenties working in North Carolina, he met an older, wealthy gentleman. One day the old man asked him, “Louis, do you want to know how to become rich?” “Of course!” Louis enthusiastically said. “If you want to be rich, Louis, you need to learn to live on less than you earn. If you earn $40,000, live on less than $40,000. Got it, Louis?” “Got it!” “Next, you need to earn $80,000. But you need to still live on $40,000. Got it, Louis?” “Got it!” “Finally, you need to earn $120,000. But you need to still live on $40,000. Got it, Louis?” “Yes, got it!” “Louis, if you keep doing that, you can’t help but become rich. And it will happen faster than you think.” 

After 25 times spending is accumulated, while keeping enough invested to keep up with inflation, then you can move to passive income town. The population there lives on the interest accumulating on their investments.

The 25 times rule assumes a few things.

• Percentage return: The S&P average return from 1926 through 2018 is 10 percent. Incorporating a 3 percent rate of inflation, that leaves a consensus average annual rate of return of around 7 percent for stocks over decades.
• Timing: The timing of retirement matters. If you retire on the first year of a major recession the math works well.
• Low investment fees: This also assumes that the majority of investments with low management fees (less than .5% annual)

Saving 25 times spending gives us the amount needed. How can we be sure it is enough? Enter the 4 percent rule.

(2) The 4 percent rule 

While it is possible to live on 40 percent of the average American salary ($24,548), it would be a modest existence. Instead, lets set a reasonable yearly salary target of $61,372, the average American salary. As discussed, at this rate, financial independence would come after $1.5 million is saved.

The 4 percent rule says that your investment portfolio of stocks, real estate, and other assets appreciate by 7 percent each year. Inflation will consume 3 percent on average, leaving 4 percent to spend reliably, until death.  The eagle eyed reader may have also noticed that this 4 percent rule has some relation to the 25 times living expense rule described above. If you were to represent 1/25 as a percentage what would it be? 4 percent.

In the worst case scenario, if you stuffed all of your cash into your mattress, living on $61,372 each year would lead to at least 25 years of draw down.

The 4 percent rule traces its origins to a 1998 paper, titled Retirement Savings: Choosing a Withdrawal Rate that is Sustainable, published by a group of professors at Trinity University. It is often referred to as the “Trinity Study.”

Although the 4 percent rule is known generally as a “safe withdrawal rate” in retirement, it is better described as the lowest safe withdrawal rate based on thirty year historical market data. Specifically, lets look at some of the outcomes of the paper:

• “Most retirees would likely benefit from allocating at least 50 percent to common stocks.”
• “Retirees who demand CPI-adjusted withdrawals during their retirement years must accept a conservative withdrawal rate from the initial portfolio.” (see illustration below)
• “For stock-dominated portfolios, withdrawal rates of 3 percent and 4 percent represent exceedingly conservative behavior. “

So lets assume an annual return on your $1.5 million over a 10 year period and see where we end up, shall we? 

7 percent return on investment

The numbers above include a draw down, which is removed from the salary each year as spending. I’ve built in a 3 percent yearly increase in that amount based on historical rates of inflation. 

In this scenario, the individual is actually richer at the end of the 11 years despite taking 60+ thousand dollars a year out of the principal. The interest is growing faster than the drawdown. 

But is this a reasonable expectation? If an individual kept their money in the market over seven decades, the likelihood of a 7 percent return is terrific.

But doesn’t the timing of financial independence matter? Yep, sure does. Lets look at the same numbers in two historical periods of the S&P 500. 

Lets begin with the 1990s

If a person reached financial independence in 1990, $200,000 would have been lost from the principal investment in the first year. However, the next 9 years would have led to a significant increase in the value of the principal. By the year 2000, the individual would have 5.6 million in the bank, despite drawing down more than 60+ thousand dollars a month for living expenses. Hard to beat those numbers. 

What if you would have become financially independent in 2000? How would the markets have treated you over that ten year period?

Financial independence in 2000

This would have been a bad time to retire. This period began with the dot com bubble crash, led to the terrorist attacks of 9/11, and culminated in the financial crisis of 2008. As a result of this historic period of negative market forces, an individual who retired in 2011 would be 635,000 poorer in 2011 than when they started in 2000. 

All of this is to say timing is uncertain and out of an individual’s control.

We’ve looked at this from the perspective of 100 percent savings in the S&P500, an unwise financial independence mix. But the 4 percent rule actually builds a 50 percent stock, 50 percent bond asset allocation as its baseline–a much more conservative savings mix.

Summary

If you save 25 times your annual spending you will reach financial independence. If you ensure that you are drawing down no more than 4 percent each year and marinating or curtailing spending from the year before financial independence, you will guarantee a sustainable withdrawal rate to death.