Financial freedom: How much money do you need?

Financial freedom: How much money do you need?

According to a study by Trinity University professors, the money needed to achieve financial freedom is equivalent to at least 25 times your annual spending. Trinity work is hugely popular in the English-speaking financial independence – early retirement community. Within the scope of this study, the percentage of the money withdrawn from a retirement portfolio was estimated using historical data from the US capital markets, provided that this portfolio can last for 30 years. Accordingly, if money is drawn from the pension portfolio at an annual rate of 4% (+ inflation rate), it is found that this portfolio will support the pensioner for 30 years with a probability of 96%. Although this study is quite popular, it has also been severely criticized.

Limitations of the Trinity study

First, I would like to emphasize that the dollar is used as the currency in this study. Secondly, the 4% rule (or 25 times the annual expenditure amount) has been put forward based on the historical rate of return of the US capital markets for 100 years. The historical average rate of return of the S&P 500 is around 10.49 percent. Let’s round to 10 percent. The average historical inflation rate is about 3 percent. Thus, the real average rate of return of the S&P 500 is almost 7 percent. However, in the capital markets, the past does not always repeat itself. There is no guarantee that historical rates of return will be similar in the future. Likewise, there is no guarantee that the US inflation rate will be 3% in the next 30 years.

Finally, Trinity study assumes that the retirement period will last 30 years. In other words, the 4% rule may not work for a retirement that lasts more than 30 years. Considering a retirement period of more than 30 years, the withdrawal rate from the portfolio must necessarily be less than 4%. The 4% rule is assumed to be ‘successful’ even if only $1 remains in the portfolio at the end of 30 years.

The amount needed for financial freedom: an example

I prepared the excel model to show you how much money is needed for financial freedom. On the left is the financial data of our imaginary person. Accordingly, I assumed a monthly net income of 50,000 TL versus an expense of 25,000 TL per month. Again, this imaginary friend has one million TL savings and zero debt. The numbers are purely fictitious. I converted these values ​​into dollars using the USD/TL rate of 17.8 TL. I also assumed the inflation-adjusted real rate of return as 7% per annum.

Under these assumptions, we need to reach a portfolio size of $561,798 as per the 4% rule for financial freedom. Under the belief that our income-expenditure ratio will not change, we get this size in about 15 years. Assuming a 3% withdrawal from the portfolio, the required amount of money is $421,348. We can reach this size in 12 years.

Financial freedom: base scenario
Financial freedom: base scenario

Sensitivity analysis

Effects of savings rate on financial freedom

Now let’s do a sensitivity analysis by changing some of our assumptions. In the example above, I implicitly assumed a savings rate of 50%. Now allow’s increase this rate to 60%. So, let’s take that while the net monthly income is 50,000 TL, our expenses are 20,000 TL per month. A 10% increase in savings reduced the required portfolio size from $561,798 to $449,438, and the time to reach financial freedom from 14 to 11 years! The savings rate is the primary variable that determines how many years you can achieve financial independence. When you increase the savings rate, you will save faster and reduce the portfolio size required for financial freedom. Also, while it is challenging to increase income, it is much easier to control and cut your spending. So let me also note that people looking to achieve financial freedom quickly often adopt a minimalist lifestyle.

Financial freedom: 10 percent increase in savings
10 percent increase in savings

Effects of the rate of return on financial freedom

This time, let’s increase the real rate of return by 1% to 8%. As seen from the table below, there was no change in portfolio size. The time to reach this portfolio size decreased from 15 years to only 14 years. The difference in the rate of return shows its effect in the long run. Suppose your goal is to gain financial freedom quickly. In that case, it is the most logical strategy to focus on increasing your savings rate instead of increasing the rate of return in the first place. Chasing a higher rate of return is a loser game.

Financial freedom: 1 percent increase in the rate of return
1 percent increase in the rate of return

Effects of the exchange rate on financial freedom

Indeed, the dollar/TL exchange rate will not remain the same for many years. So, let’s first assume that the TL appreciated by 10% against US Dollar, and the exchange rate fell from 17.8 TL to 16.02 TL. In this case, the portfolio size required for us increased from $561,798 to $624,220. However, the time to reach this portfolio size remained 15 years because the value of our savings has also increased in dollar terms.

Financial freedom: 10 percent appreciation of TL
10 percent appreciation of TL

Let’s assume that TL depreciates 10% and the exchange rate rises from 17.8 TL to 19.58 TL. In this case, the portfolio size required for financial freedom dropped from $561,798 to $510,725. However, the time to reach this portfolio size was still 15 years. Since the value of our savings has also decreased in dollar terms. We have seen from this exercise that the exchange rate does not play an essential role in our purpose in the accumulation phase. However, the exchange rate risk will arise if we decide to leave the working life after the actual accumulation phase is over. I will explore this risk in detail in my next post.

Financial freedom: 10 percent depreciation of TL
10 percent depreciation of TL

Effects of initial conditions on financial freedom

In the example we’re working on, I’ve assumed our imaginary person’s net initial savings to be one million TL. Suppose we started the financial freedom business with more luck: two million TL net savings. In this case, there was no change in the required portfolio size. However, the time to reach this portfolio size was shortened by about three years. What can I say? How you start life matters.

Financial freedom: two million TL net savings
Two million TL net savings

Is the 4% rule applicable in Turkey or other emerging market conditions?

I think applying the 4% rule on local currency-denominated assets is risky considering the conditions in Turkey. First, there is the problem of systematic high inflation and the consequent instability of the local currency. I have already written a detailed article on this subject. Instead of an unstable currency, we can make long-term investments and retirement planning with US dollars. In addition, the number of investment instruments that will consistently provide a real return of 5% or more in dollar terms is extremely limited in Turkey.

However, there is currency risk when you invest with foreign currency. For example, currently, TL is at historically low levels against foreign currencies. Let’s accept this level as given and say that we have reached the portfolio amount we targeted. So what will happen if TL appreciates 50% against foreign currencies after retirement? Our dollar-denominated income suddenly drops by 50% on a TL basis, and we become unable to meet our expenses.

A similar timing risk exists in the rate of return. Capital markets are volatile. Suppose we retired, and suddenly the stock markets crashed. Our portfolio and rate of return would be negative. We had to sell cheap shares from such a portfolio to cover our expenses. In that case, our retirement portfolio may not last for 30 years.

I will discuss these risks and possible solutions in the following posts. Keep reading.


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