How much money do you need to retire?

How much money would it take for you to have complete financial freedom? This is the amount of money you need to stop working and live the life that you’ve always dreamed of. We call it your financial independence number, because once you reach that figure, you will have earned your financial freedom.

Historically, most people only reached financial independence in retirement when they could tap into their state pension. However, it is possible to achieve financial independence before retirement age by keeping your expenses in check, having a high savings rate and maintaining an investment portfolio that grows above inflation over time.

How much do you need?

The amount of money you need to achieve financial independence will depend on the lifestyle that you want to have. If you want to live in a mansion and take expensive holidays, you will need a lot more money than the person who wants to run a donkey sanctuary in the country.

Your first step to financial independence is visualising your future and setting a few goals for yourself. Once you have something to aim for, you can start working out your financial independence number.
There are a few basic rules of financial independence.

1. You cannot be financially independent if you are carrying debt. This means that you must pay off all your debts – including your mortgage – before you can truly say that you are financially free.
2. You still need savings. Emergencies happen and you need to be able to survive them without falling into debt or shortening your financial runway. You should always keep an emergency savings fund which is topped up regularly so that you can enjoy the sense of freedom that comes with having a financial safety net.
3. You need to protect the assets and savings that you already have to avoid losing value due to external factors such as rising inflation . This might involve rebalancing your investment portfolio towards fixed income assets such as bonds.

Working out your cost of living

Once you have paid off all your debts, accrued a healthy savings pot and protected your existing wealth, you can start working out your cost of living. This will tell you how much money you need to have to maintain your preferred standard of living. It will include all your bills, your food shopping budget, any transport-related costs, holidays, clothing, socialising, and any membership fees. You should be able to review your bank transactions for the past three years to work out an annual average spend.

Bear in mind that your annual costs are likely to go down in the future. You will likely see your transport costs go down when you no longer have to commute to work. If you have children, your grocery bills and other expenses should also go down in the future when they grow up and move out of the house. You will also be eligible to claim your state pension at some point, which will provide an additional annual income stream for you and will further reduce the amount of money that you need to maintain your cost of living.

The 25x rule and the 4% rule

Now you are ready to calculate your financial independence number. This involves two very simple calculations – the 25x rule and the 4% rule.

The 4% rule

Financial independence is when your portfolio of savings and investments is big enough to cover your cost of living indefinitely. But how will you know how much money is “enough” to be financially independent.

Enter the 4% rule: a rule of thumb used around the world to determine the appropriate amount of portfolio drawdown. Based on historical stock market data, a hypothetical investor with a large enough retirement portfolio could withdraw 4% from a portfolio every year without impacting the future growth of the portfolio. In fact, the portfolio could fund the investor for more than three decades without running out of money.

To apply the 4% rule to your portfolio, you must know exactly how much money you spend every year. That is the amount 4% of your portfolio should be able to deliver every year. From there the amount you need is simple mathematics:

Your annual expenses/4%

If you are working with a substantial savings pot, this 4% should allow you to cover your annual expenses by withdrawing the growth alone and allowing your capital to remain intact. For example, 4% of £1.25m is £50,000, so if your £1.25m portfolio is growing by more than 4% per year, you should be able to withdraw £50,000 per year without touching your capital.

This is true financial freedom, where you are living off portfolio growth on your wealth without having to earn any extra money or take big risks with your investment portfolio.

Everyone’s financial independence number will be different, and your own financial independence number may change as time goes by and your priorities shift. However, it is useful to get a sense of just how much money you will need to have saved or invested before you can stop work and enjoy your life.

The 25x rule

Did you know multiplying by 25 is the same as dividing by 4%! Mind-bending, right? The 25x rule and the 4% rule is the same formula approached from a different angle.

This calculation tells you how much money you need to have saved before you can claim financial independence. It is extremely simple: just look at your anticipated cost of living and multiply it by 25.

For instance, if you believe that you will need £50,000 per year to live the type of lifestyle that you want, then you will need to build up a savings and investment pot of at least £1.25m before you can achieve financial independence. That means that £1.25m is your savings and investments target, and the amount of money that you will need to be able to live without working.

Isn’t maths fun?