As promised, we wanted to provide detailed information regarding how we arrive at the Free Time metric that will appear in many of our posts. As a reminder, this post will show you the purpose this calculation is supposed to serve (TLDR; a new and improved retirement calculator). First things first, while we will generally report one metric for each scenario, Free Time will be different for everyone.
The difference is largely driven by two factors. First, how much do you need to retire? Intuitively, a given amount of savings will have a larger impact for someone who requires a smaller nest egg to achieve financial freedom. We assume that an individual will require 70% of their annual working income after leaving their “day job”.
The second factor has to do with how far along on your savings journey you are (if you don’t know how far along you are, don’t worry, we’ve got another post just for you!). The earlier on you are in your journey, the longer you will benefit from the compounding effect of your savvy financial decisions today. If the word compounding leaves you scratching your head, no worries, we’ll get to that later. Just think of something like this:
Our baseline scenario assumes an individual making $100,000 per year, with 20 years left until financial freedom if they go along as they are now and do not engage in the financial decision at hand. We assume that one will be able to withdraw 4% of their nest egg, and that any new savings will grow at 8% annually.
Now for the meat and potatoes of this post. The crux of the solution requires answering the following question: how much will the savings you made today be worth by the time you reach financial freedom? The future value of whatever marginal savings strategy we are considering will eliminate the need to work at the back end of your financial journey, by an amount equal to the number of days it would have taken you to save this same amount in the last days of your working life. We ignore the effects of any compounding for savings that occur at the very end of your savings journey, as they usually occur for a short time and are negligible for our purposes.
There are a few simplifying assumptions we make, which don’t ultimately impact the decision making and directional recommendations. Namely, we assume a constant savings rate throughout one’s working life.
Just show me an example, will ya?
Example: Saving $1,000 extra every year for 20 years would result in roughly $50,000 of additional savings at the end of 20 years assuming 8% annual return on investment (see table below). We assume a required 70% of working level income to achieve financial freedom. Given $100,000 of annual income, this amounts to $70,000 of passive income annually. Assuming a 4% withdraw rate we arrive at a required $1.75M to achieve financial freedom.
|Year||Future Value of $1,000|
The future value of the savings from this hypothetical scenario is approximately $50,000. We define scenario 1 as the scenario in which you do not achieve these marginal savings or income enhancements. We define scenario 2 as the scenario in which you do achieve these marginal savings or income enhancements. Given that in scenario 1 you would have achieved financial freedom in 20 years, the question now becomes, if it would have taken you 20 years to save $1.75M, how long would it take you to save $1.70M?
To answer this question the final piece of the puzzle is the following, what is the constant per year savings rate that would allow you to achieve $1.75M in 20 years at 8% annual return? It turns out this number is approximately $35,409.
Were almost there! If you are saving $35,409 per year, NOT having to save $50,000 at the end of you career will result in ($50,000/$35,409/year) = 1.41 years less of work!
Clearly this analysis relies on some assumptions which aren’t perfect. However on average this should provide a good starting point to start to think about what you stand to gain from various financial decisions. Let’s see how this plays out with some real world scenarios!