Explain how a financial independence number is built from your yearly spending and a withdrawal rate.
Many people aim for a financial independence target they picked up from a forum post or a friend. It is usually a round figure, such as a million dollars or two million (common examples, not a recommendation). A round figure is easy to remember, but it comes from someone else's spending, country and pension system, so it is almost certainly wrong for you, either too high or too low.
Your financial independence number, or FI number, is the amount of invested money whose sustainable yearly withdrawals would cover your yearly spending. Two inputs decide it: how much you spend in a year, and how much you can safely withdraw from investments each year without running out. The next module covers safe withdrawals. Here you work on the first input, your spending.
Income is not part of the definition. Two people on the same salary can have very different FI numbers if one spends most of it and the other spends half. Income affects how fast you reach FI, because it decides how much you can save. Where FI sits is decided by how much you spend.
The FI number is very sensitive to spending, because every dollar you spend in a year has to be multiplied up to an invested amount. Suppose you could withdraw 4% a year (a made-up rate). Every 1,000 dollars of yearly spending would then need 25,000 dollars invested, because 1,000 divided by 0.04 is 25,000. Cutting a 3,000-dollar yearly habit of subscriptions and phone bills would lower your number by 75,000 dollars, which is 3,000 times 25 (an invented example). Cutting a recurring cost lowers the number more cheaply than any pay rise. The same works in reverse: a lifestyle that grows by 10,000 dollars a year adds a quarter of a million to the target, since 10,000 times 25 is 250,000 (also an invented example).
A guess at your spending is not good enough, and most people underestimate. They remember regular items such as rent or the mortgage, food, transport and the phone. They forget lumpy items such as a wedding gift, a car repair, a holiday, a new laptop or an insurance premium paid once a year. These can add up to a large share of the true total, and they do not stop when you stop working.
Your bank and card statements already hold the answer. Start by writing down your best guess of what you spent in the last twelve months. Then total twelve months of actual spending from your statements, and add anything you paid from cash or another account. Compare the two figures and note the gap, which shows how far your sense of your own spending is from what you really spent.
You will not use the twelve-month total as it stands. Later in this module you split it into essential spending, which must be covered every year whatever markets do, and flexible spending, which you can trim in a bad year. A plan treats the two differently, and being able to trim in a bad year is one of the strongest protections a plan can have.
The rest of this module also adjusts your spending for life after full-time work, since some costs fall when you stop working and others rise. Several of the Singapore changes are large. Your salary stops, and so do the employer and employee CPF contributions and income tax that come with it. If you go on to do self-employed work, though, you still have to make mandatory contributions to your MediSave Account, while contributions to your Ordinary and Special Accounts are voluntary. The CPF Board sets how much a self-employed person must pay, so check with them for the current amount. Employer group insurance ends, so medical cover becomes a cost you pay yourself. Insurance premiums rise with age. CPF LIFE will eventually pay a monthly income, which reduces what your own investments must cover later on. Module 3 shows how to build CPF LIFE into the number.
When you finish the module you will have a defensible spending base at today's prices and a first FI number worked out from your own spending, rather than one borrowed from someone else.
Your task: write down your best guess of what you spent in the last twelve months. Then total your actual spending from your bank and card statements, and write both figures side by side.
Write down your best guess of what you spent in the last twelve months. Then check it against your bank and card statements.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).