Principles of Financial Independence – A Beginners Guide
Financial Independence (FI) – a state in which an individual or household has sufficient wealth to live on without having to depend on income from some form of employment.
When we started out, it was somewhat daunting to realising the scope of all the topics discussed within the FI community. There seemed to be a huge amount of information to consume; books, blogs, podcasts. Most of it was US centric and needed some translation in to a UK context. What would have helped was one place to get an overview of what this Financial Independence thing was all about, the main principles behind it and how it all fits together. That’s why we felt this would be a good sticky page – an easily digestible introduction to those unfamiliar with the concept of Financial Independence and it’s components.
In theory, it isn’t difficult. If this concept is new to you, however, then there are a few things to get your head around. And whilst the main principles are fairly simple, the nuances and balance can be very interesting and are hotly debated.
Creating a beginner’s guide to Financial Independence that you specifically can follow is tricky, because everyone has a different starting point. What your journey looks like and how you go about it is an individual thing based on your circumstances, your goals and the type of person you are. There are, however, a few general overriding principles to use as your guide. The trick is to take these principles and adjust and tweak them to suite your personality, situation and goals. Make them your own. You do you.
When followed, these principles will increase your personal wealth. Even if you don’t take them to the full conclusion to provide Financial Independence which enables you to Retire Early. In and of themselves they will increase your independence, give you more control and empower you. Even if you are not fully FI and able to retire, having sufficient wealth that would financially support a few months or years’ worth of expenses, puts in you in the driving seat when negotiating with employers. It can mitigate the risk of taking the leap to set up your own business. You may wish to reduce your working hours to pursue a voluntary position for an organisation that’s important to you. Financial Independence is not about the money itself, but the time, choice and confidence that having much of it can bring.
Simply put, the aim is to save 25 times that of your annual expenses. This commonly referred to as your ‘FI number’. In principle, this amount would generate enough return, factoring in inflation, that would allow you to withdraw enough each year to cover your cost of living, without reducing the overall lump sum. In theory you can then withdraw this amount in perpetuity.
For example, if your living costs are £2,500 per month, or £30,000 per year, then you need have saved £750,000. On the basis that on average the stock market returns 7-8%, this would allow you to draw down 4% (£30,000) per year and still account for 3% inflation.
The SWR (Safe Withdrawal Rate) of 4% is the figure that has traditionally been used, based on the logic above. However, this percentage remains a topic of debate (Big Ern of Early Retirement Now has a fantastic series of articles on this) and needs to be customised to the economic climate, rate of inflation and your CoL (Cost of Living) area.
Once you are at this point, you are no longer reliant on anyone but your own financial assets and are therefore considered Financially Independent.
Maintaining a balance
There is a balance between the interplay of two factors here; the higher your expenses, then the higher the savings required and typically, the later you become FI. There is a trade-off between savings and your cost of living. The journey of FI for most people involves continually developing and tweaking that highly personal equilibrium between savings and expenditure.
It is that gap between your income and your expenditure that allows you to generate the savings you need. The bigger this gap, the higher the savings and the sooner the FI.
Let’s look at the main principles at play here.
Principle 1: Lowering your costs
Of the two, lowering your living costs is the easiest and quickest to effect. Most people will find it easier to review their expenditure and make immediate changes, than increasing their income. So, this is usually a good starting point.
The lower you get your ongoing costs, the lower your FI Number and the quicker you reach Financial freedom. Always remember that. What you save today is your future tomorrow.
Sounds obvious, but in terms of expenses, this is your single biggest barrier to increasing that savings gap and creating wealth. Not only is it an expenditure, but you are usually paying high interest rates which are designed to keep you in debt for as long as possible. If you are only covering the minimum payments, then you are going to be here a very long time. Come up with a plan to get out as soon as possible. Not easy I know. It can seem an impossible feat but make this your number one priority in life. Pursue it relentlessly. Hunt it down and think of nothing else. There are lots of resources out there to help you. Check out our article on Debt and take a look at the book Total Money Makeover from Dave Ramsey for a blue print on getting out of debt.
Reduce living costs and bills
A YouGov study in 2017 showed that 21% of Britons considered switching current accounts but didn’t go through with. The reason for this, 48% said, was thinking it would be too much hassle. Having recently done this, there is a degree of truth in this despite recent standards to improve the process. But it was worth it. Many of us have packaged accounts with benefits and these come with a monthly fee. FI’ers love reducing unnecessary fees. Take some time to make sure the benefits are of value to you and if so, that there aren’t other packages out there with better benefits at less cost. Also review interest rates; none of us are getting rich off the back of these alone at the moment, but every little counts. This is the mindset of people who are not in debt and create wealth. They reduce unnecessary costs and make marginal gains.
Fixed bills (utilities, insurance, TV and broadband)
There are tons of comparison sites out there to make sure you are getting the best deals available. Consider “cutting the cord” – this is the American term for cancelling your TV package. Do you really need all the channels, could you switch to an online only service? Resources such as Money Saving Expert will automatically alert you when there is a cheaper alternative that you are now able to take advantage of. Switching can take a few weeks but the process is generally easy and seamless. And remember – always negotiate! Spend an hour doing some research, get some like for like comparisons and be prepared to vote with your feet. Most companies are keen to keep customers, it’s cheaper than getting new ones.
Cash purchase or some form of credit?….that is the question which is hotly debated in the FI community. The usual line has always to been to buy your car outright. Wealth is created from not paying money to someone else to borrow money, whatever the guise. If that means you don’t drive a new Mercedes C-Class to keep with the Jones’, then so be it. That is the mindset of the FI’er. It’s a personal decision though and you need to consider your own financial circumstances, but always remember; the goal is to reduce your monthly outgoings and the smaller that ‘gap’, the further away your financial freedom becomes. Check out this handy guide.
The ONS shows that the average UK family spends £58 per week on food (excluding alcohol and tobacco). Anecdotally, it feels like many families spend far more than this. You can compare your spend to the weekly average over at the Money Advice Service. It is one of the quickest and easiest ways to reduce costs;
- make homemade meals (a little longer, maybe, but cheaper and healthier)
- eat out less (ONS also shows that we spend just as much, £58 per week, on eating out)
- take your own food to work (this can be a big one – analyse for a month what you spend on food and coffee whilst at work – you’d be amazed!)
The debate within the FI community rages on as to whether it is better to buy property or rent. House Price Crash has some useful calculators. If you choose the buy route, a good rule of thumb is to make sure the mortgage amount is no more than twice the household income. Whichever route you decide on, the key is not to over-stretch yourself. Keep it modest. Also consider that bigger properties require higher costs for maintenance, insurance, utilities and council tax.
In terms of your overall expenses, take in to account where you live. Is it a high or low-cost area of living? Cities like London are great for higher than average salaries, but can you off-set this against the higher cost to live there? ABC Finance have a nice statistics and guides covering the true Cost of Living (CoL) in UK cities. This area isn’t exactly a quick win, but if you’re not tied to a particular location, it can make a big difference and is worth bearing in mind.
Record, Budget, Review
When reviewing these areas, a great place to start is to set up a spreadsheet and start recording for a month or two what you spend. The results can be surprising. From there, start reviewing deals, switching suppliers and negotiating each bill. When you switch, keep a record of when that deal comes to an end and set yourself a reminder so you can start reviewing your options a month or so before renewal. This puts you in a stronger negotiating position. Then set a budget and stick to it.
Principle 2: Increase Income
If it were that easy to increase your income, most people would have done so already. We get that. While reducing your costs is a good place to make quick savings, however, increasing your income makes a powerful difference in the long run. So it’s good to start now.
Easier for those starting out than the established of course, but Careers Choice Online shows that most people will change careers 5 – 7 times in their working life. There’s different ways of looking at it. Becoming exceptional at something your passionate about is one. Entering growing / emerging industries is another. Research careers or professions that typically carry big salaries and / or partner dividends. Also consider those roles that have an element of performance related pay such as sales. When you budget to be able to live off the basic pay, those bonuses can go directly to your savings and make a real difference.
A recent article in the Independent showed that 40% of UK workers have a side hustle. There are a huge number of ways to go here, but they can be a great way to generate a second income which not only increases your overall earnings, but starts to create personal economic resilience. They can also be a powerful way to boost your moral, confidence and contentment.
Principle 3: Savings Volume and Efficiency
You need to save as much as you can, then invest it. Think of two flavours; pots that are taxed on the way out (ie, pensions) and pots that are taxed on the way in (ie, savings and investments). The balance of how you split these is personal to you. There are, however, some underlying foundations that will help.
The idea is that you save the highest percentage of your income as you possibly can by creating a savings gap though the methods outlined above. Many will shoot for 50%, some even as high as 80 – 85%. The higher the percentage, the quicker you will reach Financial Independence.
Pensions contributions are allocated before they are subject to income tax. That extra bit, perhaps just a few hundred a month, makes a huge difference through the power of compounding over the decades. Furthermore, all employers in the UK are now legally obliged to provide a work-based pension of at least 2% of your salary. They will often match what you put in. That means free money. Combined, you can put in £40,000 per year before it is taxed. Whether you max this out to the full £40k is up to you and what and when your retirement plans look like. But at the very minimum, if you are employed, you should set up a pension and match the maximum employer contribution. By doing this your employer effectively doubles the money you put into a pension and your contribution goes in tax free. The rub is that it’s locked away until you are 60 (or older, depending on future government legislation).
ISAs (Individual Savings Accounts)
There are five main ISAs;
2. Stocks and Shares
3. Lifetime (LISA)
4. Help to Buy
5. Innovative Finance.
The money you put in these individual accounts has already been subject to income tax. The benefit, is that the interest you earn from these accounts is not subject to income tax or capital gains. You never pay tax and therefore earnings do not need to be declared on your tax return. There are some conditions though; as of July 2015, you can save a maximum of £20,000 per year across all of your ISA accounts (be aware some ISAs also have their own limits such as the LISA with a maximum of £4,000 per year). Also, you can only pay in to one (of each type) each year, but you can open a new ISA with a different platform each year. Check out this Money Saving Expert guide. While ISAs don’t have the same tax advantages as pensions, they (mostly) allow you to get your money out when it is required, so an ISA withdrawal strategy could be used to bridge the gap between retiring early and being able to access your pension.
The world, quite literally, is your oyster in this regard. Investment funds, strategies and diversification are all topics on which there is a huge wealth of resources available and warrant individual discussion. The overriding principle, however, is that you minimise fees wherever possible. This includes platform, transaction fees and passive management fees, so it’s worth shopping around. Crucially though, you want to mitigate or ideally remove additional fees charged by external parties for their ‘advice’. For that reason, it is usually best to avoid expensive Financial Advisors and Fund Managers. For many people, low-cost index funds that track the stock market as a whole, provide a healthy return for minimal effort. Over the long term, stocks and shares will probably provide a better return than cash. Which funds you choose is up to you, dependent on your level of knowledge, experience and comfort. Research has shown that on average, low-cost index funds return the same yields, usually more, than expensive actively managed funds, once fees are accounted for. As Warren Buffet says; ‘A low-cost fund is the most sensible equity investment for the great majority of investors’. For UK investors it is best to fill your “tax free” wrappers like ISAs, within which you hold your investments, to maximise your tax efficiency.
Of course your investments can go up as well as down and you may get back less than what you put in. We do not pertain to offer advice here and past performance is no guarantee of future results. Do your research and do what feels right for you.
Maximising yourself in all the areas above, if starting from scratch, can take time. But it’s worth it. Enjoy it. Revel in making yourself money. It’s your tomorrow you’re saving for today. Once you’re up and running, however, it should tick along nicely on maintenance. Get yourself a spreadsheet; document your suppliers, products and contract renewal dates. Then as they come around, do your market research, renegotiate and optimise. Always look for how you can spend less on food, bills & household items.
For many on this journey to improve your financial fitness, like us, the fun is making these ongoing tweaks and adjustments. When you add them up all together, they make a huge difference.
Here’s to the pursuit of financial fitness and freedom.