Why Pinching Pennies to Get to Financial Freedom Might Not Work Out for You (and What to Do Instead)
This post was originally written for and published on Business Insider
Financial freedom sounds like the ultimate goal for most people. It means that you have enough assets that independently generate enough income for you to live off of — and you’re free from the need to earn a paycheck to fund your lifestyle.
In theory, this is an ideal way to go. But you need to be careful. The pursuit of independence can actually leave you with fewer options and feeling very much financially stuck.
The potential pitfall of financial freedom to retire early
There are a lot of bloggers who tout the “very simple math” behind reaching financial independence. Many use what’s known as the 4% rule: As long as you only withdraw 4% from your investment portfolio per year, then you will never deplete your nest egg.
If you can build up $1,000,000 in invested assets, then theoretically you can withdraw $40,000 per year for the rest of your life. Many people see this and feel inspired to slash their spending dramatically, save as much as possible to amass a million-dollar portfolio ASAP, and declare themselves financially independent.
There are some major problems here:
- This is a theory, not a guarantee. You’re betting your financial wellbeing over the long-run on the idea that things will work out in your favor.
- In the past, most experts agreed 4% was a “safe” rate, but there’s increasing debate around whether or not that’s true.
- The safe withdrawal rate was originally intended for use by people retiring at a normal retirement age of 65 or so, who needed to fund about 25 years of retired life. But if you retire at 35, then you have to fund 55 years of retirement instead.
The “simple math” for financial independence relies on linear projections. But life — and investment returns — isn’t linear. What happens in reality could look far different that what a basic calculation told you.
Not to mention, do you really want to commit to living off $40,000 per year for the rest of your life? What if your goals, values, or desires change? (And they will; we’re constantly changing who we are as people even when we consistently think our personalities are static and fixed.)
Focus on building financial power instead
The truth is, life is change. The future is unknowable. The unexpected can and does happen. So whatever financial strategy you follow, it should account for these realities.
Here’s what I suggest instead of trying to get to a minimum level of assets to be considered financially independent, only to find yourself locked into a specific annual spending amount for the rest of your life (because you can only take out so much from your investments to ensure you don’t run out of money in your lifetime):
Focus on building financial power. This means looking at strategies to build significant wealth that provides for flexibility and choice in your life now and tomorrow.
This can look a lot like a pursuit of financial independence, and if you use this strategy long enough you will become financially free. The difference usually comes down to pace and timing.
The goal of financial power is not to get to a minimum amount of assets as quickly as possible so you can quit your job. The purpose of financial power is to:
- Put the focus on increasing your income so you can save and invest — but still be able to leverage some of your cash flow for what you want to enjoy today (instead of putting everything off for “later” when you’re financially independent).
- Align the money you use now and in the future with your values, whatever those may be … and then building self-awareness to understand what doesn’t matter as much to you, so you can say “no” to spending on what doesn’t provide as much value to you.
- Invest strategically — in yourself, in the financial markets, in a business, or other vehicles that are most appropriate for you — so that your money is working as hard for you as you worked to earn it.
How you can build more financial power into your life
The formula for building financial power is pretty simple at first glance:
Earn more + spend less + invest the rest.
Easy in theory; incredibly difficult to do in practice. But difficult doesn’t mean impossible. Start by breaking things down into small, bite-sized actions. It’s not about making huge leaps forward; it’s about consistently moving toward the end goal over time.
If you want to earn more, you may want to start researching new positions (in your current company or with a new employer) that offer higher wages. Or take on additional responsibility in your current role and use that to negotiate higher pay at your next review.
Feeling more entrepreneurial? Start a side hustle — or even a side business. You don’t need to figure out how to launch the next Apple; just doing something part-time on your own (instead of spending your free time on another Netflix binge) can help boost your income.
Once you generate extra cash flow, put it to work. Look to max out retirement accounts and HSAs, then consider opening a taxable brokerage account in which to invest more funds.
If you’re a DIY investor, then consider looking into low-cost index funds with companies like Vanguard or Fidelity. That will allow you to access a large range of investment options while minimizing fees.
Otherwise, consider reaching out to a fee-only financial adviser who will work as your fiduciary if you want more support and guidance in building financial power for yourself.