What is FIRE (Finance Indepdence Retire Early)?
FIRE is an acronym for "Financial Independence, Retire Early" and it's exactly as it sounds. The movement suggests that one can be "financially independent" and "retire early" when they have accumulated a portfolio of investments to a specific amount. The whole premise of FIRE is based on two major elements; the 4% rule, and frugality. Let me explain.
What is the 4% rule?
In the mid 1990's, a financial advisor Bill Bengen wanted to see if there's a "sustainable" rate his clients can withdraw each year from their portfolio (invested in the market) without depleting it over an average retirement span of 30 years. So he went back to historical market data since 1926, accounting for inflation, market downturns, etc. and looked at 30 year periods starting at different times. His conclusion was that 4% was the worst-case scenario such that given an arbitrary portfolio amount, one can safely withdraw that amount from that portfolio each and every year, starting in the worst possible year to retire, and still have money left in that portfolio after 30 years. This is the basis of the 4% rule, or what the FIRE community known as the safe withdrawal rate.
How does the 4% rule (safe withdrawal rate) work?
Historically speaking the stock market (i.e. S&P500 index) has an average return of roughly 7.5% annually, in fact it's actually higher today at 10.1% ( https://www.officialdata.org/us/stocks/s-p-500/1926) due to recent bull market in the 2010's. But for the sake of demonstration, we'll stick to commonly accepted 7.5%. Next, historical inflation is at an average of 3.5% annually, although it's a tad higher today at 3.8% ( https://www.worlddata.info/america/usa/inflation-rates.php), again we'll stick to 3.5% for this example.
(i) Inflation is the rate at which goods and services rise. Remember when McDoubles used to cost CAD$1.39 + tax? Now it's CAD$3.79 + tax? That's phenomenon is called inflation. Materials and labour costs increase over time, making the money we have less valuable over time as it buys less goods and services.
Given that market returns at 7.5% per year, accounting for the inflation at 3.5%, then we should be able to consume 4% of the portfolio every year, while maintaining the real value of original starting portfolio to keep up with inflation:
+7.5% return ($7,500)
-4% withdraw ($4,000)
= $103,500
+7.5% return ($7,763)
-4% withdraw ($4,140)
= $107,123
As you can see, the portfolio continues to rise with the inflation, and so does the amount you're withdrawing to ensure that you can continue to buy the same amount of goods and services, despite inflation making it more expensive every year.
Nuances of the 4% rule
The subject of the 4% rule is actually much more complex, and there are many variations, simulations and mathematical methods to test for success of a given withdrawal rate. Even the way one goes about withdrawing can vary.
The example above is strictly to demonstrate roughly how it works, but you'll hear other variations, such as withdrawing 4% of your initial portfolio, and then indexing (increasing) it yearly with the inflation rate of that year. For the purpose of this blog post, we will use the 4% as our safe withdrawal rate.
How does FIRE work?
Now that you understand the 4% rule as a safe withdrawal rate, let's talk about how it plays into FIRE! Since we know that given a portfolio value of x, we can safely withdraw 4% of that portfolio, this then becomes a simple algebra problem. If we also know how much we spend annually, then we can work backwards to figure out how much we need in our portfolio!
Let us assume your annual spending is $50,000, then we divide that by 4% to arrive at a portfolio amounting to $1,250,000. So if you are reasonably confident about spending within $50,000 a year going forward, and you have $1,250,000 invested today, then you are considered to have achieved FIRE in the traditional sense, based on the 4% rule.
What does frugality have to do with FIRE?
Frugality means we can save more towards our desired portfolio, as well as reducing our annual spending needs, which in turn reduces our portfolio goal as well. Take the example above, if you were able to reduce your annual spending by $5,000 to just $45,000, that means your target portfolio is now $1,125,000, a reduction of $125,000! Which means that you can achieve FIRE even sooner.
And there you have it! That is the fundamentals of FIRE (Financial Independent, Retire Early). It is by no means a guaranteed success once you hit your target portfolio. All of this is based on the findings by Bill Bengen, on historical market data, and the 4% rule is more like a general rule of thumb rather than a law of physics. The truth is no one can predict the future, how good or bad the market will perform, how high or low inflation would be, and as some would suggest "past performance does not guarantee future results". It does, however, provide us a framework to play around with.