Retirement/Financial independence isn’t an age; it’s a number. Here’s what to focus on to ensure you’re working toward your goal.
PIMD welcomes the White Coat Investor. WCI is a physician-specific personal finance and investing website. The White Coat Investor can help you to become financially literate and disciplined, which will allow you to spend your time and effort on your patients, your family, and your own wellness. WCI truly believes that a financially secure doctor is a better partner, parent, and practitioner. White Coat Investor is an affiliate partner of PIMD.
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
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.