This article was written by our guest Ed from Investing Simple. All thoughts expressed are solely those of the author. This article is written for educational purposes and not to provide investment recommendations or financial advice.
Over the last decade, financial independence has become a popular topic, especially among millennials and younger generations.
The “Financial Independence, Retire Early” or FIRE movement has taken social media and online forums by storm. Now there are even entire websites and podcasts based on the FIRE strategy.
But what exactly is the FIRE movement?
In this article, we will outline FIRE strategy and help you decide if its something you should consider adopting.
How Does the FIRE Strategy Work?
The FIRE strategy is a saving, investing, and spending formula that can be applied to anyone no matter the age.
The FIRE strategy focuses on the idea that people should live well below their means, accumulate the maximum amount of savings possible, and wisely invest their savings.
Eventually, the strategy suggests that your passive investments should be able to accumulate so you will no longer need to actively work.
The FIRE idea really is a complete lifestyle strategy when you begin to understand how it works.
FIRE is based on 3 key principles:
- Each year save up to 70% of your annual income
- Set a total savings goal of 30 times your annual expenses
- Live off your savings/investments by taking 3%-4% withdrawals
The FIRE strategy suggests maxing out your savings while you are young and in your working years. This could mean saving up to 70% of your annual income. You then invest all your savings into a portfolio that can earn at a minimum a 3% to 4% average return annually.
Once your savings total 30 times your annual expenses, you may then be able to retire and live off your investments by taking 3% to 4% withdrawals from your account.
By investing your savings into a portfolio that earns 3% to 4% annually on average, theoretically, you will never have to draw down your account. In essence, you will be living off of the annual returns in your account. Many FIRE proponents use index funds to reach their investment objectives.
By using your passive investments to live, you will then have the ability to do what you want with your life. You will no longer have to worry about actively trying to make money.
FIRE Retirement Example
To give you an idea of how the FIRE strategy works, here is an example:
Ryan is a 24-year old pilot for a well-respected airline. He will earn a salary of $80,000 this year. Ryan would like to adopt the FIRE strategy, so he saves $50,000 per year. His expenses total $30,000 per year.
According to the FIRE strategy, Ryan will need $900,000 dollars to retire (30 times his annual expenses) and live off his investments.
Now assuming his salary, savings, and spending stays constant, Ryan will be able to retire in approximately 12 years assuming an annual rate of return of 7%. This means Ryan will be 36 years old when he retires.
Once Ryan is 36 years old, he should be able to live off his $900,000 investment account by taking 3% to 4% withdrawals each year. As long as his investment account earns on average a 4% annual return, Ryan should be able to keep his nest egg and live off the growth or income it generates each year.
FIRE Strategy Caveats
If you are new to the FIRE retirement strategy then you may be skeptical, and you should be. After all, why aren’t more people attempting this strategy?
I think the important thing to understand is that FIRE is not just a saving strategy, but a way of life. Living well below your means is not as easy as it seems.
Most people do not have the diligence and determination to save most of the money they make. And even if they can, it is very difficult to let your cash build up through investments and not lay a single finger on it for years or decades. This is especially true if your life changes dramatically, such as when you have kids.
Lifestyle inflation is also a common occurrence when people begin making more money. This is one of the main reasons why the FIRE strategy does not work for most people. As people begin making more money, they typically begin spending more money.
Lifestyle inflation can significantly decrease your savings rate and increase the time frame to your retirement.
Another caveat of the FIRE strategy is that investors must be able to earn a reasonable return over time and avoid poor investment decisions. This means investing in a relatively aggressive portfolio, of mostly stocks, in order to earn substantial returns.
Over the last 50 years, the S&P 500 has returned on average an 8% annual return. However, investors must be able to build portfolios that limit their risk but ensure adequate returns. Taking on too much risk can erode returns over time.
Lack of budgeting diligence, lifestyle inflation, and making poor investment decisions are all reasons why people fail at the FIRE retirement strategy.
Who is FIRE Not For?
The FIRE strategy is not for everyone. It can be a difficult strategy to undertake, and most people will not even attempt it.
For the type of people who enjoy living a comfortable lifestyle and the occasional frivolous spending, the FIRE strategy is not for you. FIRE requires diligent saving and spending habits.
If you struggle to maintain a basic budget, you may want to avoid the FIRE strategy, too. Unless you are in for the challenge to learn more and change your habits, the FIRE strategy may be a difficult feat.
You may also want to avoid the FIRE strategy if you plan on spending more in retirement. The FIRE strategy requires 3% to 4% withdrawal rates. If you are spending well beyond your maximum withdrawal rate, then you will eventually exhaust your savings.
Before you stop working, I would recommend creating a retirement budget. This way, you can plan for any unforeseen expenses and get a better understanding of your expenses after your working years.
FIRE Strategy in Summary
The FIRE strategy has become a well-known discussion in modern personal finance. For those who are up for the challenge, the FIRE strategy could change the way you look at work.
Moving towards an early retirement or simply having the choice in how you spend your time can be life-changing.
What are your thoughts on the FIRE strategy? Leave a comment below!
Ed Canty is a personal finance enthusiast and financial planner. At his blog, investingsimple.com, he covers investing, budgeting, taxes, and many other topics. At his day job, Ed works as a financial planner helping clients navigate their financial needs. Ed is currently attending Northwestern University to pursue the CERTIFIED FINANCIAL PLANNER™ certification.
This article is written for educational purposes and not to provide investment recommendations or financial advice.