[calculating_fi]

Your Real FI Number: How To Calculate It

Financial independence, retire early (FIRE) proponents tout the 4% rule as the end-all, be-all, but this is grossly oversimplified - retirement length, withdrawal rate, sequence of returns risk, changes in spending habits, and supplemental retirement income all need to be considered when projecting a defendable FI target

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Most people only calculate their FI number using the simplest formula available and never stress test it. Conventional wisdom says that $100,000 in passive income requires an investment portfolio of $2,500,000. This feels real because it's concrete and tangible, but looking at a number in a spreadsheet versus living through a 30% market drawdown in year-one of retirement are two different things.

On paper, the strategy behind financial independence is simple - grow your investment portfolio to a point where it can cover your passive retirement burn rate - but the difficult part isn't the math, it's accounting for several other variables that are often overlooked.

In this post, I'll walk through the approach I used to calculate my own FI number, including a withdrawal rate calibrated to retirement length, sequence of returns risk, a worst-case year one drawdown scenario, and accounting for supplemental retirement income (e.g., Social Security, and for my Canadian friends, Canadian Pension Plan and Old Age Security).

STEP 01

Start With Your Annual Spend

The presumption underpinning every FI calculation is your annual spend target (e.g., $100,000 per year, passive). This is fundamental, as it underpins all subsequent assumptions and calculations, but is often underestimated for two reasons:

• First - spending is calculated based on current burn rate, not retirement burn rate. This is often different and dynamic for several reasons. Expenses in retirement can be lower due to a paid off mortgage, elimination of child care costs, etc., and on the flip side, other spending categories may increase such as medical expenses, travel and leisure, charitable giving, etc. Both sides (increases in some areas, decreases in others) need to be considered when estimating your retirement burn rate.

• Second - people often ignore or underestimate taxes. Your FI number needs to fund your after-tax lifestyle, not pre-tax. Investment income and withdrawals are often taxed - traditional 401(k) and IRA withdrawals are treated as ordinary income, and realized capital gains in taxable accounts are subject to the federal capital gains tax (and, depending on your state of residence, state-level taxes). For sake of example, a $10,000 per month after-tax lifestyle may require $12,000 - $14,000 per month in gross (pre-tax) withdrawals depending on the specific account mix and state of residence. Focus on the gross figure, not the net one.

KEY TAKEAWAYS
1) Properly project your spending in retirement - do this by evaluating post-retirement spending, not pre-retirement spending
2) Calculate your gross withdrawal cash flow requirements, not just net - taxes are a real drag
3) Factor a 10-20% margin of safety - inflation, lifestyle changes, market underperformance, and unexpected costs are real risks
4) For the Americans, make sure to budget explicitly for healthcare before Medicare eligibility (age 65) - ACA premiums for a family often run $1,000 - $2,000 per month

STEP 02

Choose the Right Withdrawal Rate for Your Retirement Length

The 4% rule is the most widely cited retirement target in personal finance, and rightfully so. This figure isn't accidental, it originated from the Trinity Study, which modeled historical US equity returns and concluded that a 4% withdrawal rate, adjusted periodically for inflation, had a high probability of sustaining a portfolio for 30 years. While useful for the average retiree, it's biggest flaw is assuming a 30 year period - this doesn't align to most in the FIRE (financial independence, retire early) movement!

For my specific situation, reaching FI at 35 and planning retiring in the next few years, I need to plan for a 50-year time horizon! Over this duration, a much more conservative withdrawal rate must be assumed - a longer runway means more years of compound withdrawal, more years of sequence of returns risk, and more risk of spending changes and general projection errors.

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Based on historical analysis, retirement horizons beyond 40 years should assume a 3.25-3.5% withdrawal rate to ensure portfolio survival. For my 50-year time horizon, I'm comfortable with a rate between 3.25-3.5%.

RETIREMENT LENGTH	RETIREMENT AGE	SUGGESTED RATE
30 years	~55-60	4.0%
35 years	~50-55	3.5-3.75%
40 years	~45-50	3.25-3.5%
50+ years	~35-40	3.0-3.25%

KEY TAKEAWAYS
1)The 4% rule assumes a 30-year retirement horizon - your specific withdrawal rate may be different depending on retirement length
2) For my own retirement planning (35-40), I assume a conservative withdrawal rate of 3.25%
3) Each 0.5% reduction in withdrawal rate significantly increases your portfolio size requirements (e.g., $100,000 per year at 4% is $2,500,000 invested; $100,000 per year at 3.5% is ~$2,857,000 invested)
4) Utilizing a flexible spending approach - reducing withdrawals by 10-15% in down years will considerably improve survival odds

STEP 03

Stress Test: What Happens if the Market Drops 30% in Year One?

Sequence of returns risk - the impact of experiencing a significant downturn early in your retirement (especially year one!) - is a topic that most FI guides simply gloss over or ignore entirely. I'd argue that this is one of the most important dimensions when evaluating your retirement portfolio target.

Let's use an example - investor A and investor B. They both retire at the same time with identical portfolios and identical average annual returns over 30 years. The only difference is timing - investor A experiences a significant market drawdown early on; investor B experiences a drawdown at the end. The results? Investor A runs out of money, investor B ends with a surplus. Same average return, same initial balance, same retirement date, opposite experiences. The sequence of returns, not the average of returns, is what largely determines portfolio survival. A 30% drawdown isn't a fantasy either - if you had retired in 2008 or 2020, you would have experienced this exact scenario - reducing a $3.5M portfolio to $~2.5M.

To help address this risk, I recommend evaluating the following:

• Define a 'stress-tested' FI number. This figure helps determine exactly what your portfolio needs to sustain a steep drawdown early in retirement. The result is a meaningfully higher number than initially planned, but one that can confidently sustain a steep market correction early in retirement.

• Plan to add a 1-2 year cash buffer. This helps you avoid selling equities during a steep correction.

• Utilize dynamic spending rules. Be flexible with spending (especially during a downturn), look at reducing burn rate by 10-15% to help compensate

• Diversification. Ensure that your portfolio is not overly concentrated.

KEY TAKEAWAYS
1) Sequence of returns risk - especially significant drawdowns in early years - is a material reason why early retirement portfolios fail
2) A 30% year-one drawdown on a $3.5M portfolio leaves ~2.5M - stress test your numbers against this potential scenario
3) A 1-2 year cash buffer eliminates the need to sell equities during a correction - this prudent approach addresses most sequence risk
4) Flexible spending (reducing withdrawals in down years) dramatically improves long-term survivability
5) Portfolio concentration amplifies sequence risk

STEP 04

Accounting for Retirement Income - Variable(s) That Changes The Math

Most FI calculators often highlight retirement income from your investment portfolio, but doesn't represent the entire picture. Income during retirement is often supplemented by the government, pension, or a defined benefit (DB) plan.

Social Security (SS), Canadian Pension Plan (CPP), and Old Age Security (OAS) - the latter two for Canadians - provide meaningful inflation-indexed income that begins at a set age regardless of your portfolio size or performance. For someone planning to retire early, say between 35-40, that income is still decades away, but still significant enough to model as a meaningful floor later in retirement.

Let's assume your annual spending target is $120,000 and your portfolio needs to fund this entirely, your FI number at 3.5% is roughly $3,500,000, but once you hit 65-67, Social Security (and/or CPP and OAS) might collectively provide tens of thousands of dollars per year of supplemental income. The result? Your portfolio only needs to fund $65,000 - $80,000 per year once you hit that age, resulting in a significantly lower withdrawal rate (<2%). The math for the last 25 years of a 50-year retirement window is dramatically better than the first 25 years, and this substantially improves the odds of portfolio survivability (i.e., your portfolio will outlast you!).

In my scenario, as a Canadian working in the US with plans to eventually retire in Canada, this becomes much more nuanced. SS benefits are calculated on a 35-year earnings history and are subject to the Windfall Elimination Provision if you also receive CPP (which I will be). I am eligible for both CPP and OAS as I worked ~10 years in Canada before moving to the US. Ensuring that I'm maximizing all of these factors requires planning - and a cross-border CPA is essential for this.

KEY TAKEAWAYS
1) Government income (SS, CPP, OAS, etc.) and pensions can cover a significant portion of projected cash flow from age 65-67 onwards, drastically reducing the portfolio drawdown requirements.
2) Model projected government income conservatively - I recommend using an ~80% rule of thumb to account for potential policy changes
3) Understand potential clawbacks if you receive parallel pensions/benefits, for example the Windfall Elimination Provision. In my case, as I am planning to receive both Social Security and Canadian Pension Plan, this must be accounted for.
4) For a 50-year retirement, the final half (supplemented by government income) is far safer than the first half

STEP 05

Calculating Your Number

The formula is straightforward, but adjusting the inputs based on your personal circumstances is where the complexity begins. I've included a few example tables to give you an idea of how to plan for annual spending and target withdrawal rate. This includes a base case, stress-tested case (30% year-one drawdown), and a reduced government income scenario (maybe Social Security doesn't exist in the future!).

Exhibit 1 - your base FI number (annual spend / withdrawal rate); assumes 20% tax:

Annual net spend	Gross withdrawal	@ 3.0%	@ 3.25%	@ 3.5%	@ 4.0%
$60,000	$75,000	$2,500,000	$2,308,000	$2,143,000	$1,875,000
$80,000	$100,000	$3,333,000	$3,077,000	$2,857,000	$2,500,000
$100,000	$125,000	$4,167,000	$3,846,000	$3,571,000	$3,125,000
$120,000	$150,000	$5,000,000	$4,615,000	$4,286,000	$3,750,000
$150,000	$187,500	$6,250,000	$5,769,000	$5,357,000	$4,688,000
$200,000	$250,000	$8,333,000	$7,692,000	$7,143,000	$6,250,000

Exhibit 2 - stress-tested FI number (assumes a 30% drawdown in year one):

Annual net spend	@ 3.0%	@ 3.25%	@ 3.5%	@ 4.0%
$60,000	$3,571,000	$3,297,000	$3,061,000	$2,679,000
$80,000	$4,762,000	$4,396,000	$4,082,000	$3,571,000
$100,000	$5,952,000	$5,494,000	$5,102,000	$4,464,000
$120,000	$7,143,000	$6,593,000	$6,122,000	$5,357,000
$150,000	$8,929,000	$8,241,000	$7,653,000	$6,696,000
$200,000	$11,905,000	$10,989,000	$10,204,000	$8,929,000

Exhibit 3 - how supplemental govt./pension income impacts your FI number (65+):

Supplemental income	Portfolio reduction @ 3.0%	Portfolio reduction @ 3.25%	Portfolio reduction @ 3.5%
$20,000/yr	$667,000	$615,000	$571,000
$30,000/yr	$1,000,000	$923,000	$857,000
$44,000/yr	$1,467,000	$1,354,000	$1,257,000
$55,000/yr	$1,833,000	$1,692,000	$1,571,000
$70,000/yr	$2,333,000	$2,154,000	$2,000,000

REAL LIFE EXAMPLE - EARLY RETIREE AT 35, $100K/YR NET SPEND:
- Annual net spend target: $100,000
- Gross withdrawal needed (20% tax rate): $100,000/0.8 = $125,000
- Withdrawal rate (50-yr horizon): 3.25%
- Base FI number: $125,000 / 0.0325 = $3,846,000
- Stress-tested (30% yr. 1 drawdown): $3,846,000 / 0.7 = $5,494,000
- Expected supplemental government income (SS + CPP + OAS): $44,000/yr. -> potentially reduces portfolio need by $1,354,000

WHAT IS THE ANSWER? IT DEPENDS ON YOUR TAX RATE AND RISK TOLERANCE.

-Conservative FI target: $5,494,000 portfolio
(100% stress-tested and assumes 0% govt. supplemental income)

-Moderate FI target: $4,140,000 portfolio
(100% stress-tested and assumes 100% govt. supplemental income) 

-Aggressive FI target: $2,492,000 portfolio
(0% stress-tested and assumes 100% govt. supplemental income) 

STEP 06

What the Formula Doesn't Catch

Models are projections, and as a result, carry inherent risk and may be inaccurate. We do our best to minimize this through exhausting all potential scenarios and factors, but life is often full of surprises. Here's a few other areas worth considering as you begin modeling your FI target.

• Healthcare - if you retire early, you'll encounter a gap between your employee-sponsored insurance and Medicare eligibility at 65. Market premiums for out-of-pocket insurance can run $1,000 - $2,000 per month for a family, and are income-sensitive (i.e., the more you earn the more you'll pay). Thankfully, this is less of a concern for me as I am planning to retire in Canada (+1 for universal health care). Additionally, elective procedures should be prioritized while you're still under an employee-sponsored plan, as these may not be covered under out-of-pocket or Medicare insurance plans.

• Inflation - for a 50-year retirement horizon, the buying power of $1 at 3% annual inflation will erode to $0.23 over this time. Your spending targets, modeled in today's dollars, will need to fund a lifestyle where everything will cost more in the future. Robust FI calculators use real returns (nominal minus inflation) to help counter this and provide a more realistic target.

• Lifestyle drift - the burn rate you calculate today may not sustain over the next 10 or 20 years, life happens! You may encounter a significant lifestyle change in the future (e.g., having kids, or moving) that must be accounted for. I recommend modeling an initial FI number that accounts for these potential changes and increase in spend. Additionally, retirement creates more time, and more time may result in more spending (especially in your younger years when you have an abundance of energy and health). Be mindful of this and continue to diligently track your spending, and make adjustments as needed.

• Portfolio concentration - a broadly diversified portfolio experiencing a 30% market drawdown is significantly different than a highly-concentrated one experiencing a sector-specific correction. With a diversified portfolio, we can more confidently assume a reversion to the mean (and continued growth) over time (it may not be immediate, but the market will recover in the following months and years). With a highly-concentrated portfolio, you can't make the same assumption - it's critical that your focus shifts from capital appreciation to capital preservation once you begin approaching your FI target. A 30% drawdown on a $300,000 portfolio is nearly $100,000 - it stings, but is recoverable. A 30% drawdown on a multi-million dollar portfolio is catastrophic.

-Healthcare costs before 65 need to be considered, they're an additional $12,000-$24,000+ cost per year for families that most models omit
-Ensure that you're using real returns when modeling, not nominal. This is critical to ensure that your portfolio is 'inflation-hedged', the formula to follow is nominal returns minus inflation rate (e.g., 8% nominal returns - 3% inflation = 5% real returns).
-Your FI number is an initial target, but must be revisited and retested often, I recommend at least quarterly. If you're a FIRE enthusiast, you'll likely enjoy this activity...
-Concentration risk must be considered, begin diversifying once you near your FI number

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In Summary

When I first calculated by own FI number (annual spend divided by withdrawal rate) I was quite excited and optimistic - the end was near! However, when I re-calculated it using a stress-tested number, hedged it against an aggressive year-one drawdown scenario, and accounted for 50-year retirement horizon at a more conservative 3.25% withdrawal rate, it required a much higher figure (which thankfully was partially offset by supplemental retirement income). There are still risks with this number, but I'm much more confident in this my revised figure - it has a much higher probability of supporting me (and my future wife and kids) going forward.

Financial independence is not just a number. It's a level of risk about the future that you are willing to accept. Regardless of your risk appetite or personal circumstances, I believe everyone would benefit from running an initial FI calculation - get an idea of where you are at and how far (or close) you are from making work optional!

Happy calculating.

MAK