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Step 3: Goal Setting

You’ve sat down and hammered out a concrete list of your values and what your ideal lifestyle looks like. You’ve talked to your partner and made sure you are both on board with this FF dream (or if you are single, you’re making sure you are looking for a future partner who can share you goals).

Now its time to set the waypoints on your path to FF. It’s so vital to have long-term and short-term goals when you approach any challenge in life. The long-term goal allows you to set a clear target for success and act as the carrot way down the road. The short-term goals keep you motivated day to day, giving you a psychological high each time you reach one, and providing a great reason to celebrate the milestones! Short-term goals also give you a smaller window of time from which to forecast, and the flexibility to adapt and modify when things don’t go exactly as planned.

The key to setting both short-term and long-term goals is that each one be specific, measurable and achievable. Meaning you can very clearly measure your progress or determine when you have reached a goal, and the goals are within your ability to attain. Now that doesn’t mean the goals have to be easy, you can really push yourself here. But setting a goal of developing a way to go to Mars when you have no background in any field related to space travel, (and you’re not Elon Musk), well that doesn’t really fall into the realm of an achievable goal. (Not saying you can’t do it, just that there’s probably going to be some other pretty big long-term goals you need to achieve before you set that doozy).

When it comes to finance, saying “I want to be rich and retire early”, is not specific, nor is it sufficiently measurable. What is rich, and what does early mean?

Examples of specific goals would be: “I want to retire in 10 years or less”, “I want to cut my annual expenses by 20%”, or “I want to pay off my credit card debt in 6 months”. Each of the examples have a clear target (specific), definitive time frame, (measurable) and are realistic (achievable).

When thinking about your goals for FF, start with the long-term. If you’ve done Step 1, you’ve figured out what wealth is to you, but when exactly do you want to get there? Do you hate every minute of your job and need to get out ASAP just to maintain your sanity? Or do you somewhat enjoy what you do and can continue to do it for awhile longer? What is your debt/income situation? Your current life and financial circumstances should all play a role in deciding a timeframe for when you can realistically achieve FF.

Setting this goal brings about another big question. How much do I actually need to retire? Frankly, there’s no simple answer, it really depends on what your ideal lifestyle consists of, so you should start by having a fairly accurate estimate of how much your lifestyle is going to cost you on an annual basis. That number will depend heavily on the area in which you choose to reside once you reach FF. You can easily live off $10,000 annually in some places of the world, while others require substantially more. So thinking about your ideal lifestyle, and the cost of living in your chosen area, what are your annual expenses going to be?

For us, we wanted to ensure we were able to comfortably sustain $75,000 per year. That seems like quite a bit, especially compared to other Financial Independence enthusiasts out there. But again, this was about OUR ideal lifestyle and OUR comfort level. Without a mortgage or rent to pay for, we calculated that $50,000 annually is ample for us to live on, AND we can set aside $25,000 per year outside of our retirement fund. Why so much, and why save outside the retirement fund? Well, remember how back at Step 1 I said that people are very poor at predicting our future wants? Well that $25,000 annually addresses exactly that flaw. It’s our buffer zone, or if you prefer, our rainy day fund. We probably won’t touch it in the first few years, but after that maybe we will want to do something a bit different. Maybe Mike will decide we really do want a boat after all, or perhaps a vacation home somewhere warm. Or maybe we want to dive back into investment real estate (which is the most likely of those three.) Bottom line, we want to make sure we have sufficient capital available to fund any future ventures or experiences we may want to pursue. We also want it to be separate from the retirement accounts that fund our day to day life, thereby limiting our risk exposure if we do choose to invest in something.

Neither Mike or I could comfortably retire without knowing we would be putting away a big chunk of change annually to fund future options. It was also important for us to see this money as an expense that our income sources fund, but is maintained separately from our retirement accounts. That way if an opportunity arises that we are interested in pursuing, we know exactly how much capital we have available to invest without exposing our retirement funds (read day to day life) to unnecessary risk.

So once you have an idea of how much your lifestyle will cost annually, you can do two things. You can develop sufficient and diversified sources of passive income that fund that annual amount AND/OR you can save a sufficient lump sum and invest it to allow you to live off the gains. But how much would you need to save?

Many people in the Financial Independence world abide by what’s called the 4% rule. So what is the 4% rule, and is it worth following? The rule originated from a study done in 1994 by financial planner William Bengen. Bengen looked at withdrawal rates comparative to the historical rates of return, and determined that a withdrawal of 4% of the principal amount was the highest rate at which you could sustain your principal over a period of 30 years. This 4% also factored inflation into your withdrawal rate so your annual income isn’t devalued over time. But it is important to note that Bengen reached this conclusion based on historical rates of return, and although past performance is usually the best predictor of future behaviour, there is simply no guarantee that the markets will perform in a similar fashion in the future.

If the markets perform well, you may end up with a substantial amount of money left over in the end (lucky kids), but where there’s an upside there is always a downside, and conversely you may find yourself running low on funds earlier than expected if your retirement happens to occur in an extremely poor market environment (or if you haven’t diversified appropriately and taken on too much risk exposure).

The take away is the odds are on your side that 4% will be a sufficiently conservative withdrawal rate over the long term, and it provides an excellent starting point from which to structure your goals, BUT there are never any solid guarantees. Which means it’s important to maintain some degree of flexibility in your annual expenses.

In our case, if we experience a particularly poor run in the markets over a span of years (especially in the early years), perhaps we’ll elect to lower our expenses or draw from the capital we’ve set aside rather than pulling from our retirement accounts. Or if we hit a particularly good run (in our later years), perhaps we’ll recalculate and withdraw a bit more than usual to fund a once in a lifetime opportunity or experience. Our approach undeniably deviates from the underlying principle of the 4% rule, being the law of averages, but in retirement there are simply too many variables to just follow one concept blindly. It will always be important to know what your money is doing and reassess whether or not your current approach is working for you. As much as you don’t want to run out of money early, you also don’t want to end up with a huge amount of money left over and wish you had done more.

So if you take the 4% rule as a starting point, that would mean Mike and I required either a lump sum of $1,875,000 of invested savings to generate our targeted 4% (1,875,000 x .04 = 75,000), $75,000 of annual income from passive sources, or a combination of those two. For us, we’ve elected to go the combination route, diversifying our passive income streams and building our investment savings.

So lets give a couple examples of how you can calculate how much you need to save, and/or generate through passive income.

Example 1: Your ideal lifestyle will cost you $30,000 annually. You want to retire in 10 years, and you don’t have any passive sources of income you will be able to rely upon outside of your savings.

The first step is to calculate the total savings you will need to fund your retirement lifestyle. ($30,000 x 25 = $750,000).

The second step is to take that $750,000 and divide it by the length of time in which you want to retire, in this case we have said 10 years. ($750,000/10= $75,000).

You’ll need to find a way to save $75,000 each year for the next 10 years in order to have sufficient principal to withdraw $30,000 annually (+ inflation).

Example 2: Your ideal lifestyle will cost you $30,000 annually. You want to retire in 5 years. You will have paid off your mortgage by the end of that 5 years and will generate rental income from your basement suite to the tune of $1500.00 per month (this rental rate also grows with market inflation).

First lets figure out how much income you will be generating annually from your basement suite. Keeping in mind that your mortgage will be paid off in retirement and therefore any rental income generated will be going directly to your bottom line. ($1500.00 x 12 = $18,000).

Now, subtracting that rental income from your annual amount, lets calculate how much you will need to generate from your invested savings. ($30,000 – $18,000 = $12,000).

Whats the total savings required to generate an additional $12,000 of annual income? ($12,000 x 25 = $300,000).

Divide that by the number of years you have until retirement ($300,000 \ 5 = $60,000). You will need to save $60,000 annually over the next 5 years to draw $12,000 of annual investment income. That $12,000 combined with your $18,000 annual rental income funds your retirement.

By setting the goal of when you want to achieve FF, and knowing the approximate cost of your ideal lifestyle, you can identify exactly how much money you need to save annually, and/or how much passive income you need to build in order to reach FF.

So take your estimated cost of living for your ideal lifestyle, and the number of years until you want to reach retirement, and apply one of the two equations listed below:

Annual Lifestyle Cost x 25 \ number of years until retirement = annual savings amount; OR my preferred approach,

Annual Lifestyle Cost – Annual Passive Income Sources x 25 \ number of years until retirement = annual savings amount.

From that equation you will have a specific and measurable goal, but is it achievable? Make sure the amount you need to generate annually in savings/passive income is realistic comparative to your current life circumstances. Your FF goal should be aggressive, but not unattainable.

Once you have that number, its time to start looking at your short term goals. This is where we want to start assessing how to cut expenses and increase income, and we’ll address both these topics in the next posts!


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