Friday, October 4, 2013

Moving the goalpost

It's been about a year now since I first noted that our goal of paying off our mortgage—up until then, the main target of all our efforts at saving—was coming into view out on the horizon, and started wondering what we should do with our money after that. Unlike many couples our age, we don't have any kids to put (or at least assist) through college, and while we do need to save for retirement, I was thinking of that as a goal that was still a couple of decades away at least. After all, I reasoned, we both like our jobs, so there's no reason to retire early...and even if we wanted to, we'd need at least one full-time job between us for the health benefits.

However, since then, I've learned three important things that have helped change my mind on this point:
  1. While Brian is pretty happy with his job, he doesn't really love it so much that he'd definitely want to keep doing it even if we no longer needed the money. In fact, he would really like to have the option of retiring early, whether he decides to do it or not.
  2. Under Obamacare, our estimated cost for private health insurance will drop to about $7,750 per year. This, according to the Kaiser Family Foundation's Subsidy Calculator, is what the two of us would pay for a "Silver plan," which means one that would cover about 85 percent of our health expenses and would guarantee that our out-of-pocket expenses in a given year could not exceed $4,500. It's also nearly $4,000 less than the best price I could previously find at, an online shopping mall for health insurance. (I considered only those policies that actually had an out-of-pocket maximum, which was a surprisingly small percentage of them, considering that the whole point of insurance is to protect you against catastrophic costs.)
  3. If Brian were to lose (or give up) his job, we would also qualify for a health insurance subsidy. Based on my average annual income since I first became a freelancer, we could get about 80 percent of our insurance tab picked up by the government. This makes surviving on one income—or even no income—a much more realistic possibility.
So, now that we have finally succeeded in making our final mortgage payment, I'm officially setting my sights on a new goal: Financial Independence.

The term "financial independence," or FI, gets bandied about a lot in personal finance blogs and articles, and people use it in several different ways. The "Declaration of Financial Independence" on the Dollar Stretcher website lists a wide variety of criteria for FI, from "being comfortable with the things you have" to "having sufficient retirement savings." Trent Hamm of The Simple Dollar, in a 2008 post, gets a little more specific, outlining three different levels of financial independence. Level one is "freedom from financial reliance on loved ones" (i.e., earning enough to pay your own way); level two is "freedom from financial reliance on creditors" (being out of debt); and level three is "freedom from financial reliance on income" (having enough to retire whenever you choose). This third level is also the definition used by Amy Dacyczyn (all hail the Frugal Zealot!) in an article called "The Unemployment Opportunity," which appears in her third Tightwad Gazette book. This top level of financial independence—also known as being independently wealthy or having "walk away from it all money"—is what we're looking to as our new financial goal.

One point Dacyczyn notes in her article is that a key to achieving this level of FI is to reduce your living expenses as much as possible. The less you need to live on, the less you need to have saved up to provide you with enough interest to pay all the bills. In fact, when I started doing some very rough back-of-the-envelope calculations to estimate how many years it might take us to reach FI, I made an interesting discovery: when aiming for FI, cutting $5,000 from your annual expenses is much more beneficial than adding that same $5,000 to your income. One reason is that the extra $5,000 in earnings will be taxed (and since it's tacked on to your current income, all that extra money will go into your highest tax bracket). When you cut expenses by $5,000, by contrast, that whole amount goes into your savings. But even more importantly, reducing expenses helps you in two different ways: it both increases the amount you can save each year (speeding up the rate at which you can move toward your FI savings goal) and decreases the amount you need to live on (making the goal number itself smaller).

To illustrate, let's take an aspiring saver whom we'll call (what else) Rich. Rich currently earns $55K per year after taxes, of which he spends $30K and saves $25K. Assuming that his investments can bring in roughly 4 percent interest per year—a reasonably safe bet, based on the historical average for the federal funds rate—Rich would need $750K in the bank to bring in enough for him to live on ($750K times 4 percent equals $30K, the amount he spends now). Rich already has $250K socked away, so he needs an extra $500K to become financially independent. If he continues to save $25K per year, it will take him 20 years to reach this goal ($500K divided by $25K equals 20).

Now, suppose Rich gets a raise that increases his income to $60K a year (again, after taxes). Since FI is his goal, he pumps all this extra cash into savings, increasing his annual savings to $30K a year. With these increased savings, he'll need only 16.67 years to reach FI ($500K divided by $30K equals 16.67). So, he'll get there 3 years and 4 months sooner than he would without the raise, which is good news.

But, suppose that instead of earning an extra $5K, Rich had instead found a way to save an extra $5K each year by cutting his expenses. He's still saving $30K a year, but now his savings goal is lower: since he only needs $25K a year to live on, he only needs $625K to bring in that amount in interest. With the $250K he already has, he only needs to save an additional $375K. And if he's now saving $30K per year, he will reach that goal in just 12.5 years ($375K divided by $30K equals 12.5). This means that he's just shortened his time to FI by 7.5 years—more than twice as much as he was able to shorten it by earning an extra $5K.

So (to get back to a real-life example), I'm looking on the mortgage we've just freed ourselves from as our opportunity to be like Rich. It's reduced our annual expenses (since our only housing payment now is our property taxes), thus making FI a more reachable goal for us, while simultaneously boosting the amount that we can put away toward it each year. Now all I have to do is figure out the best way to invest that extra money so that we can move toward our new goal as steadily as possible.
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