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Methods to determine if you have reached financial independence…

There are several ways of determining when you have reached financial independence (FI). I will outline 3 methods starting from the simplest to the most complex. As any self-respecting financial blogger tends to point out, past performance is not indicative of future results, so keep that in mind when choosing the method you are most comfortable with.

Trinity Study Method

The easiest, and the default way most FI bloggers generate their number is through using the “Trinity Study method.” For those that are unfamiliar, the Trinity Study, a 1998 paper by three professors of finance at Trinity University, found that if you could limit yourself to withdrawing 3% to 4% of your portfolio on an annual basis, you are extremely unlikely to exhaust any portfolio of stocks and bonds during your lifetime. They back tested this theory by studying stock market data starting from 1925 and continuing through 1995.

The way this method is applied is by taking your monthly spending, or how much you think your monthly expenses would be in retirement, multiply by 12 to determine your annual spending requirement, and then multiply by 25 which is the inverse of 4% or if you would like to be more conservative 33 which is the inverse of 3%. Using my budget post as an example my number would be:

$6,888 x 12 x 25 = $2,066,400      or if I were to be more conservative      $6,888 x 12 x 33 = $ 2,727,648.

So, as you can see, we would need investment or savings of at least $2.0 – $2.8 million to be able to safely withdraw 3% to 4% and not worry about running out of money.

Of note, if you have a pension, which being in the military we shall receive IF we remain active for at least 20 years, you can subtract that amount from your monthly spend. In that case, if my wife and I each have a $2,500 per month pension, our number shrinks to:

($6,888 – $5,000) x 12 x 25 = $566,400      or to be more conservative      ($6,888 – $5,000) x 12 x 25 = $747,648

Thus, the pension makes a huge difference in the amount we need to save. If you don’t have a pension, remember Social Security could be deducted as well. Just as a FYI, only 17% of active duty military make it to the full 20 years, so for planning purposes in the FI/RE household, our savings goals are set to the former example as opposed to the latter.

Funded Ratio – Immediate Annuity Calculation

The next method requires you to calculate your funded ratio, or according to the financial dictionary “A ratio of a pension or annuity’s assets to its liabilities. A funding ratio above 1 indicates that the pension or annuity is able to cover all payments it is obligated to make.” The funded ratio gives a point in time analysis of how your assets compare to your future liabilities. In other words, will your money outlast your expenses. So, in layman’s terms you divide the amount money you currently have saved/ invested, by the amount of money you need saved/invested in the future to generate the income you need to live.

The tricky part is you need to figure out how much your money today is going to be worth in the future, because remember inflation is a silent killer of savings (just ask your parents/grandparents how much milk, gas, and a loaf of bread cost when they were kids).

Fortunately, there is an easy way to calculate this number so there is no need to learn about present value, discount rates, and other financial lingo, unless you are into that kind of thing, then proceed. Instead, what you can do is go to:

and use their annuities calculator. The calculator will generate a rough estimate on the amount of money you need to put into a life annuity, which is an annuity that will pay you a specific amount of money per month, guaranteed, for the rest of your life. The number the calculator spits out will serve as your denominator, and the amount you currently have saved/invested will serve as your numerator. Divide the two, and if your number is greater than or equal to 1, Yahtzee, you have won the game. Again, using my budget post as an example:

**You have to use a real e-mail, but they will not spam you.




Estimate of the amount of investments/savings needed to have an inflation adjusted $6,888/month guaranteed for life.

According to the output, we would have to put about $2 million in this annuity to receive $6,888 of inflation adjusted income for the rest of our lives. To calculate my funding ratio, if I had $500,000 in savings or investments:

Funding ratio = $500,000 ÷ $2,035347 = 0.24

This number would represent a snapshot of my current situation, and I would periodically rerun this calculation to see how I am progressing toward my goal. Again, once the ratio is 1 or greater, I could theoretically retire.

By the way, the difference between the two quotes is the “No Death Benefit” option (smaller number) leaves no money to my beneficiaries should I die before or while receiving the income. With regards to the “Cash Refund” option (larger number), my beneficiaries would receive the entire balance if I die before receiving the benefit, and would receive the remainder of the balance if I have already starting receiving the benefit.

Funded Ratio – Spreadsheet Calculation

The final method is to use the Funded Ratio spreadsheet, kindly provided by the Bogleheads forum at the following link:

Using this spreadsheet, you will have to know or have an estimate of the following parameters:

1.                        Estimated years in retirement: it’s best to be generous here, since we don’t want a situation where                                 we out live our money

2., 5., 7., 10.    Estimated real discount rate: Deciding on the right discount rate is incredibly important. Using a                                       higher discount rate means that cash flows out in the future (both spending and potential income) will                             be less important. A lower discount rate will mean that those future cash flows will have a bigger                                         impact because they are discounted less. The most conservative discount rate would be if you used                                   the risk-free treasury rate (TIPS), in which you would only be discounting the future value by around                                 1%-3% at most. If it’s good enough for Warren Buffet, it’s good enough for me. In the example in the                                   spreadsheet, I used 2% or 0.02.

3.                          Estimated expenses (yearly) in today’s dollars: self-explanatory.

4.                          Number of years until retirement: self-explanatory.

6.                          Estimated years of Social Security: If you don’t think you will have this benefit, set it to 0.

8.                          Yearly Social Security Income: take your best guess or head to                                                                                                    to get an estimate..

9.                          Number of years until Social Security starts: self-explanatory.

11.                        Estimated years of pension: set to 0 if you do not have a pension.

12., 15.               Estimated Inflation + Discount Rate: The US Bureau of Labor Statistics estimates the average annual                               inflation rate to be around 3.77% from 1957 until now. Add 2% for the discount rate to come up with                                 5.77% or .0577.

13.                        Yearly pension payment: self-explanatory.

14.                        Number of years Until Pension Starts: self-explanatory.

16.                        Portfolio Value: Enter the amount you currently have saved/invested.

Using the example from above, if I had $500,000 in savings or investments, and a monthly spend of $6,888, with no pension, and no social security, the spreadsheet generates the following value:

Funded ratio = $500,000/$2,267,701 = 0.22

If I were to include our potential pensions of around $2,500 each, the spreadsheet generates the following value:

Funded ratio = $1,659,423/$2,267,701 = 0.73

Again, we see the power of the pension getting us much closer to reaching our #1 goal.

Hopefully these techniques can be a valuable tool for you in planning for your retirement. Whatever method you decide to use, be diligent about saving and maximize your dollars so you can finally get off of the hamster wheel.

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