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Financial Independence is the need of the hour
This is a story of a 25-year-old Udit. Udit, is a software engineer, working for the past 2 years in an MNC. He has a decent salary & is doing relatively well at his work. Yet, Udit’s aim is to retire by 40. What? Retire by 40? Yes! Udit, a young representative of Gen Z, raised by parents who worked till the age of 55-60, is thinking of retiring in his 40s.
Is it even possible?
Well, “Only Time will Tell” & of course Udit as well, but 15 years later.
However, we can’t ignore the fact that Financial Independence (also termed as Financial Freedom) is a buzzword these days. This relatively unheard concept 4 years back has now become the talk of the town, especially in the financial community. It’s not only Gen Z, even Millennials in their 30s & early 40s have taken a liking to this concept.
It is time for us to delve deeper to understand all about this!
What is Financial Independence (FI)?
Before that, let’s ask why we need money? To cater to our daily necessities, weekend parties, monthly bills, EMIs, yearly premiums and decadal dreams! In short we need money to survive, live & thrive. So, FI is a state where you don’t need to worry about money for the above. We gain the freedom and ability to use our own time as per our wish and for the causes/passons we believe our time is worthy of. That means you have so much money that you don’t need to work to earn a living. The month end message of salary credited, surprisingly doesn’t matter to you much, because your expenses are no more dependent on your monthly paycheck.
The chief proponent of financial independence is the FIRE movement -Financial Independence, Retire Early. FIRE Movement is said to originate from a 1992 best selling book by Vicki Robin & Joe Dominguez as well as the 2010 book by Jacob Lund Fisker.
Through online podcasts, social media & discussion forums this FIRE movement spread, literally like fire. Those seeking to achieve FIRE choose to intentionally maximise their savings rate by increasing income & decreasing expenses. They also invest aggressively into assets that could provide passive income in the future. The aim is to accumulate a big corpus, & sources of passive income that can reduce the dependency on jobs. Ultimately, you achieve a state wherein your finances can dictate when you retire, rather than your age.
There are 4 basic variants of FIRE:
- Lean FIRE: Minimalist living, to survive on relatively smaller corpus & some passive income
- Fat Fire: Maintain a good standard of living, requiring a bigger corpus & multiple sources of passive income
- Barista FIRE: Less paying, but stress-free part-time job in addition to Fire Corpus & sources of passive income. Live a comfortable standard of living.
- Coast FIRE: Accumulate a corpus in the form of investments (by 30s or 40s), shift to part-time job & let investments compound to fund a completely retired life at the age when one is unable to work anymore (by 60s).
The thumb rule for the corpus is around 25 to 30 times the annual expenses. The idea is that with a withdrawal rate of 4% post FIRE, & 50:50 allocation to equity & debt one can ensure the corpus lasts in retirement years. Sources of passive income help you keep a lower withdrawal rate. No one, literally no one, wants to run out of their money before they die!
All this does sound hale & rosy. However, it’s time to remind what my college professor always said: “Never do anything without understanding it’s purpose.”
Why is financial independence required?
There are multiple reasons. In fact it’s totally subjective, meaning everyone can have their own reasons to achieve FI.
Let us look at a few of them:
- Changing social fabric
The earlier generations lived in a village system wherein everyone knew each other. A difficulty for one family was a difficulty for all. Joint families were prevalent & even distant cousins were as close as real siblings. This shared ecosystem ensured financial support during difficult times & that financial burden never fell on a single member. Lack of resources was overcome by pooling of resources amongst the village dwellers. Community dominated competition amongst individuals & individual families.
With urbanization, people moved to cities & the joint family system crumbled. A nuclear family is left to fend for itself for any financial need, say a health emergency. This increased the dependence on the source of income, and the loss of this income meant doom for that family! Financial independence can help avoid this.
Globalisation has brought both global luxuries & global worries right in our drawing rooms. A virus that originated in a city of China led to a mass exodus of workers from the metros to the villages of India. Many families lost their sole earning member in the COVID pandemic. Businesses shutdown overnight during lockdown, some never to open back.
Similarly, the ongoing Russia Ukraine war and the impending recession could mean job losses for some of us. People are increasingly aware that the prosperous fabric of a family stitched by steady salary, can rapidly unravel at the seams, when there are salary & job cuts. FI is the probable solution to avoid dependence of the entire family on monthly income
- Work life balance & health
A job in the yester years was about fixed working hours & minimal travel times. A person could leave all work at the office and be free to relax, engage with self & family. Today extended work hours are the norm. Living in big cities means staying away from workplaces to save on living costs, leading to greater travel times. So the average time spent for a job, by any office goer in big metro cities like Delhi, Mumbai, Bangalore is anywhere close to 12-13 hours. Moreover work never leaves you as it is now in your pocket & your backpack. Add to it, the work from home culture that has further blurred boundaries between work & home.
FIRE has made people realise this sacrifice of family & personal time. Lifestyle diseases such as high blood pressure, hypertension, diabetes that are catching the young, have created awareness towards the health impact of overworking. These are also the motivators for FI & as a chance to quit such a lifestyle forever.
- Passion Vs Prison of Safety
Not everyone has a job that he loves & is passionate about. Some realise it late that their passion lies somewhere else & that is when the job starts losing it’s appeal. The advent of the internet & a connected world mean, people can pursue passion projects. They can even generate value out of it. Knowledge & skills necessary for such passion projects are easy to get by.
As said by Naval Ravikant:
The inability pursue one’s passion makes it difficult to continue in toxic workplaces or under an unreasonable boss. However, monthly paycheck, yearly appraisals, promotions feel safe & have the acceptance of the society around. Life seems predictable & since colleagues are in the same boat, it feels safe. But, there is a constant tussle between passion & prison of safety, that makes people lean towards FI.
- Time independence
This could be the biggest advantage of financial independence. A person quitting a full time job after achieving FI can own his time. He can choose to spend time with family, be closely involved in the upbringing of the kids & even support ageing parents. Moreover, time is available to enjoy life when healthy & full of energy. Working long hours in stressful workplaces sucks the life out of people when they retire in their 50s & 60s. Financial independence allows an individual to dictate life as per his terms rather than being at the mercy of fixed workplace hours.
Another major driver for FI is that people yearn to work on their pursuits & passions, but they are unable to find time. FI promises time independence, which can allow the writer stuck in the syntax of software codes, to pursue writing. It can allow the artist doodling during mundane meetings to pursue his art. It can also allow an activist looking to bring social change to be free of the constraints of his job. FI can allow an individual to try multiple passions & pursuits thereby adding to the overall happiness & satisfaction in life.
Achieving FIRE although seems the key to a happy stress free life. But, it cannot be achieved without a well chalked out financial plan.
Let us see in the next section, how financial planning can help you achieve FIRE.
A financial plan is essential to achieve the necessary corpus to become financially independent. Moreover, a financial plan should also account for life after FIRE, when you may not continue the high paying job. The plan must ensure you do not outlive your money during your lifetime.
There are 3 phases about a FIRE financial plan:
- Accumulation Phase
A phase when you accumulate the corpus necessary to achieve financial Independence. Perhaps the easiest phase since, you try to maximise savings rate & any extra income from assets, side hustles etc. is ploughed back in as investments. More & quicker you save & invest, the faster you accumulate.
Let’s take the example of our friend Udit earning a monthly income of Rs. 40000 at the age of 25. His current monthly expenses are Rs. 12,500. Udit wishes to retire by the age 40. Assuming an inflation rate of 8%, the Rs.1.5 Lakh annual expense of Udit will balloon up to 4.75 Lakh after 15 years. As per the thumb rule, Udit can be financially independent if he accumulates a corpus 30 times of 4.75 Lakh i.e. about 1.4 Cr.
To accumulate that much corpus let’s assume Udit invests Rs. 25,000 monthly in various investments that are a combination of equity, debt, gold etc. Let us assume the overall rate of return of his total portfolio as 12%. In 15 years he can accumulate a total corpus of about 1.26 Cr. So, Udit might need a couple of years more to achieve his aim of Financial Independence.
Please note, for the sake of simplicity we haven’t assumed any rise in expenses owing to Udit’s life stage e.g. marriage, kids etc. We have also ignored salary hikes & additional sources of income that Udit may have in the future.
- Conservation Phase
This is the phase when Udit will be of the age of about 32-35 years. He would have accumulated a decent corpus, however there are still some more years to go. This phase involves re-assessing one’s lifestyle expenses & re-calibrating investments based on the final goal. Udit will have to become debt free, & shift some money from high risk investments to moderate risk ones. The idea is to safeguard the accumulated capital from any shocks, as well as grow it.
Following decisions may need to be taken after a re-assessment:
- Revision of the target FIRE Corpus based on current lifestyle expenses
- Increase in investment amount
- Re-alignment of investments to reduce risk
- Modification of portfolio composition to have a healthy mix of safety & growth
- Withdrawal plan
Post FI, you may choose to leave the earlier high paying job entirely, work a part time job or stop having any regular work. There would also come a phase when, you will stop having any income be it due to ill-health or simply due to over-age etc. This requires a withdrawal plan, wherein the existing corpus would need to yield income. The assets accumulated would be sweated & money accumulated would also be withdrawn to provide for the living expenses..
If our friend, Udit, wants to completely leave the job & indulge in his passions, he needs to stick within the limits of the withdrawal plan. Any indulgences, say vacation, can be taken only in the bracket of this withdrawal plan. Remember, a financially independent Udit, cannot afford to take on any debt to fund his lifestyle. In absence of a regular job, a debt could be disastrous. At the same time, Udit has to ensure the corpus isn’t eaten away by inflation, since he has at least 30 more years to live by. Needless to say, this phase is one of the most difficult phases of FIRE and needs meticulous planning.
Apart from the above, there are some more important components of a financial plan.
- Zero debt & liabilities
- Emergency fund: At least 12 times of monthly expense
- Separate investments for financial goals such as kids education, marriage etc.
- Adequate health insurance for Individual & family member
- Life insurance for dependents
- Passive income: Rental income, Dividend income etc.
Life after FIRE
Majority people who have achieved FIRE don’t completely retire. They either work part time jobs, earn from their passion projects or even keep working regular jobs. Some people claim that being FI, increased their engagement at work & have also improved their work quality. They could say no to assignments they weren’t passionate about or even demand roles, without worrying about any repercussions on appraisals, salary & promotions. Some choose to freelance, eventually turning that into a business.
However, as we said earlier, life after FI will be comfortable only, if you have a solid withdrawal plan. A withdrawal plan will ensure you have sufficient income out of your assets & your FIRE corpus, to manage day-to-day expenses without degrading your lifestyle.
There are 2 strategies for a good withdrawal plan:
- SWR – Safe withdrawal rate strategy
This involves using the highest safe withdrawal rate that would have a survived number of historical scenarios. A 1990s research paper, popularised by the name “Trinity Study”, indicates that a portfolio of 50:50 in stocks & bonds (debt instruments), would at least last 30 years, if the withdrawal rate is kept 4% of it in 1 year and then increased each year to account for inflation. Recently it was shown that the 4% rule remains valid even for India.
- Bucket strategy
In the bucket strategy, you keep the annual expenses for the next 1-5 years in liquid instruments like cash, FD etc. The amounts needed for the next 5-15 years should be kept in a debt heavy portfolio i.e. (70:30 in favour of debt) while the remaining money which is for the 15-30 years period should be kept in equity heavy portfolio (i.e. 70:30 in favour of equity. This needs periodic re-balancing
There is no substitute for equity when it comes to inflation. A part of the portfolio should remain in equity. However, periodic re-balancing is the key to ensure your portfolio isn’t too risky neither prematurely runs out, in both the above strategies.
The Gen Z and Millenials are no longer looking at a life wherein the better years are only spent earning a livelihood. They are actively seeking FI to live a fuller life wherein they control their own time. Contrary to general perception, FIRE doesn’t mean a permanent withdrawal from society. It doesn’t mean you stop being useful to the country or economy by not contributing. FIRE in fact allows one to engage meaningfully with society, contribute in areas which we love and also improve quality of life.
Being financially independent as a concept & the idea of:
- Being one’s own boss
- Owning one’s time
- Not being bound by a 9-5 routine
does seem exciting. There are proven estimates & thumb rules for FIRE. These are derived by experts after studying actual returns of equity & debt markets in the past years. However, be mindful that more fiction is created in a spreadsheet than in books. Hence, it’s prudent to take adequate margins in calculations & consider conservative return estimates in the financial plan. Achieving the necessary corpus & ensuring we don’t outlive it, are the key drivers of the financial plan. However, the size of the corpus and the kind of life post FIRE are subjective. At the end we must remember, FI isn’t a race, it’s a journey to be taken at one’s own pace!