Know your financial freedom number
Is financial freedom one of your objectives? Many people say they would like to achieve financial freedom. Have you ever thought of this as a goal for yourself? If you haven’t until now, it is probably a good time to start thinking about it.
But what is it exactly? I think of financial freedom as that point in life when you have enough wealth and/or passive income that you do not have to work to ensure your living expenses anymore and could retire if you wanted to.
Of course, most high-performance people don’t stop working altogether. They like what they do so much that they don’t want to give up on it. Work that you love brings meaning and fulfillment in life. What is important for them is their mission and objectives that they have set for themselves. The financial freedom comes as a bonus.
Some people can reach this goal as early as their thirties. For others it may take more to get there, but may come to this point in their forties or fifties.
However, there are many who never reach this goal and end up old, with health problems and living from month to month on a state pension. There is nothing wrong with that, but if you end up in that bucket, life is not going to be easy for you at that point. So if you want to avoid that situation, you may want to start thinking of some better options.
How to measure financial freedom
In order to start on the path of achieving your financial freedom goal, you must first determine a metric that would tell you when you have reached it. I call this metric the Financial Freedom Number (FFN). Simply put, this is the value where your self-worth needs to be in order to ensure you can sustain yourself throughout your retirement. Ideally, this value should be not simply money stored in a bank account, but in various assets that can generate cash flow.
Financial Freedom Number simplified formula
Let’s see how you can calculate this for yourself step-by-step, assuming your goal is to retire around 60-65 years old:
- Determine what is the exact amount that you need for Monthly Expenses (ME) right now. In order to do this, you should record any expense you make for a few months and average it out. Once you have figured out what your monthly expenses projection is, move to the next step.
- Multiply what you obtained at step 1 by 12. This is the value of your current average yearly expenses.
- Multiply the amount from step 2 by 25. On average, you would expect to benefit from 25 years of retirement (RY), so this is the number we will use for the calculation.
The final amount obtained after step 3 is the total amount you will need, in order to be able to retire for 25 years, on your current expenses level. In a nutshell, the above can be condensed in a simplified formula, as follows:
FFN = ME * 300
Financial Freedom Number general formula
The more generalized formula is a little more complex, allowing for various adjustments. It uses the average Monthly Expenses (ME) and number of Retirement Years (RY), and a Hazard Factor (HF) as variables. The formula looks like this:
FFN = ME * 12 * RY * HF
What is new, when compared with the simplified formula, is the Hazard Factor. This HF allows you to include some forms of misfortune in your calculation. There are many forms of “bad luck” that can occur in your lifetime – it may happen that you lose your home to an earthquake, or your health is affected by a serious disease that requires a significant amount of money to get over. For such things we need an extra margin of wealth, that can be used in case of emergency.
The HF should always be set to a value greater than 1. I typically set mine at 1.2, thus allowing for a 20% margin for “rainy days”.
Other possible adjustments you might want to make to the FFN calculation include:
- Earlier retirement – If you plan to retire at an earlier age than what was assumed above, you need to adjust the calculations accordingly, by adjusting the step 3 multiplier to the appropriate number of years.
- Increased expenses – If you feel your current expenses do not reflect the standard of living that would make you happy, you should increase your estimated expenses to something that you think would make more sense for you.
Take some time and calculate your Financial Freedom Number right now.
How to use your FFN value
The Financial Freedom Number can help you to determine:
- Is your income to the proper level, so that you can retire in a decent amount of time?
Divide the FFN by your Monthly Income (MI) to determine how far away from financial freedom you are (Years To Retirement – YTR), if you keep earning your current income.
YTR = FFN / MI / 12
You may not like this result, but you have to know it, if you want the chance to actually do something about it. - What is the income I need to earn in order to reach financial freedom in a certain amount of time?
Plan when you would like to retire (set Years to Retirement to a specific number – e.g. YTR = 20). Divide the FFN by the YTR to find out what your yearly income needs to be in order to reach this goal. From this you can calculate what your Required Monthly Income (RMI) needs to be.
RMI = FFN / YTR / 12
If this Required Monthly Income (RMI) is significantly lower than your current Monthly Income (MI), you need to start looking at options to increase your income.
Either way you choose to utilize this instrument, it will give you a clear view on where you are versus where you need to be. In my case, having a clear picture of where I am is a really important motivating factor.
Please let me know what you think about this in the comments below. Also, you can check out other strategy-related posts here.