We track our finances closely to understand our progress towards financial independence (FI), but are not comfortable sharing our exact financial situation online. Great, a personal finance blog that won’t share personal finance info.To get around this, I have decided to share our finances by normalizing the numbers by our annual spending. This provides two benefits. First, I am actually comfortable sharing the information in this format since you don’t know our annual spending. Second, it shows the data in terms of the (reciprocal) safe withdrawal rate framework–where we know we need to save up a certain multiple of our annual spending to achieve FI.
With the graphical summaries below, I–and you–can benchmark our progress. How badly will our expenses creep up over time? Will we ever actually generate passive business or real estate income? How close are we to achieving our FI goals? Of course my real intent is not to share our financial situation. Rather, it is to help you see the importance of tracking your own finances, and provide you with one way of doing so. Here are the steps involved:
Calculate annual expenses
Understanding your annual spending is crucial. You achieve FI when your portfolio (1) reaches a “safe” multiple of your annual expenses and (2) is invested with an asset allocation that can support safe withdrawals over your retirement horizon. We use Personal Capital to track our expenses, so I have good data spending data for 2018 onward. I also subtract passive income from our annual expenses to calculate our net annual spending as follows:
Net annual spending = annual spending – passive income
The reason being that passive income can cover a portion of our living expenses and reduce the burden on our investment portfolio. The graph below tracks our net annual spending relative to our 2018 levels. Since only 2018 data is included for now, the graph is not very insightful. However it will clearly help us track changes in spending behavior and passive income generation.
Record assets and normalize by annual expenses
Next, tally up your assets. This includes retirement accounts, taxable brokerage accounts, bank accounts (or equivalent), home equity, investment real estate equity, and business equity. Divide (normalize) the value of each asset by your annual expenses. This shows you how all of your assets stack up compared to your annual spending. Here is our relative net worth as of December 31, 2018. You can see that we had a net worth just over 5x our annual expenses, with retirement accounts and home equity dominating.
Set your savings target
We are aiming to be FI by age 45 (year 2032) with a portfolio of 30x our net annual expenses. The 30x goal reflects Kitce’s article showing a long term safe withdrawal rate of 3.5%. The reciprocal of 3.5% is 28.5x net annual expenses, which we have rounded up to 30x. Our Investor Policy Statement shows the asset allocation and investment hierarchy we are using to achieve these goals.
Focus on invested assets
When calculating your portfolio requirements for FI, you need to exclude home equity. That’s not to say home equity is useless; owning your home outright reduces your living expenses and required portfolio size. But you can’t count home equity as both an asset and a means of reducing living expenses. Similarly for investment real estate equity and business equity; they only generate passive income as long as you continue to hold them. As soon as you sell and realize the equity, your passive income drops accordingly.
The graph below shows our relative net worth in terms of invested assets. I have separated accounts into conventional retirement (CR) and early retirement (ER). Conventional retirement accounts include 401(k)s, IRAs, and HSAs. Early retirement accounts include our taxable brokerage accounts and bank accounts. At the end of 2018 we sat at 3.5x, which is not surprising since we only started pursuing FI that year. The market drop in December 2018 didn’t help the numbers either.
Account for compounding
True investments have positive expected return, which will compound over your earning horizon. The compound growth reduces how much of your own earned money you need to save and invest. Of course you can’t predict future returns, let alone count on them to carry you over the FI finish line. Nonetheless, I find calculating the expected compound growth useful for visualizing our distance from FI. The graph below shows our relative invested net worth including compound growth to age 45. It predicts our current assets will be worth about 7.5x by the time we are 45. The other 22.5x needs to be generated in the intervening years.
Record your progress every year and adjust course as needed
Revisit your numbers yearly to monitor your spending, passive income, account balances, and expected compound growth. If you are moving in the right direction, the bars will move closer to the target over time. Once the solid bars overtake the target, you have reached FI. If things aren’t going well, at least you can recognize it and identify changes to make.
One final comment on projecting compound growth
Just to reiterate: I am not proposing you bank on the projected growth; that would be counting your nest egg before it has hatched. But I think the benefit of visualizing the projected growth outweighs the inherent uncertainty in the growth rate. The projected growth also has a built in regulating feature. If you are relatively far from FI, your longer compounding horizon is more likely to deliver the long term average growth rate. Conversely, if you are near FI, you are less reliant on compound growth to hit your target. A few more years of diligent saving and investing will push you over the finish line.