Home Personal FinanceFinancial Freedom In 5 Simple Steps Financial Freedom Step 3: Goal Setting

Financial Freedom Step 3: Goal Setting

by Phia @ Freedom 101

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 Financial Freedom dream (or if you are single, you’re making sure you are looking for a future partner who can share your ideals). Now what about goal setting??

It’s vital to your success to have both 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 acts 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. Which translates to the flexibility to adapt and modify when things don’t go exactly as planned.

The key to goal setting is to keep them 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.

Photo. courtesy of Kelly Sikkema on Unsplash

Now that doesn’t mean the goals have to be easy. 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.

So What Goal Should I Set For Financial Freedom?

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”
  • “We want to cut our annual expenses by 20%”
  • “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 should be realistic (achievable), for your unique circumstances.

When It Comes To Goal Setting……Start With The End

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?

Do you want to retire at all, or is Financial Freedom about changing your language from have to work to choose to work? What is your debt/income situation?

Your current life and financial circumstances should all play a role in deciding a time frame for when you can realistically achieve Financial Freedom.

The Big Q – How Much Do I Need?

Setting your time line always brings about another big question. How much do I actually need??

Frankly, there’s no simple answer. It really depends on what your ideal lifestyle consists of. So the place to start is by establishing a fairly accurate estimate of how much that lifestyle is going to cost you on an annual basis.

That number will depend heavily on the area in which you choose to reside when/if you retire. 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 desired area, what are your annual expenses likely to be?

What We Did

For us, we wanted to ensure we were able to comfortably sustain $75,000 per year.

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.

Maybe Mike will decide he really does want a boat after all, or perhaps we’ll spring for a vacation home/investment property somewhere warm. Or maybe we’ll want to dive back into investment real estate locally.

Bottom line, we wanted to make sure we have sufficient capital available to fund any future ventures or experiences we may want to pursue.

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 to unnecessary risk.

So How Much Do I 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.

Conversely 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 our money is doing and reassess whether or not our current approach is working for us. As much as we don’t want to run out of money early, we also don’t want to end up with a huge amount of money left over while wishing we had done more.

So taking 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.

Here’s a couple examples of how you can calculate what you’re going. to need:

Example 1: $30,000 p/year – 10 Years To Retirement

Calculate the total savings you will need to fund your retirement lifestyle. ($30,000 x 25 = $750,000). Divide that by the length of time in which you want to retire, in this case we have said 10 years. ($750,000/10= $75,000).

Outcome: 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: $30,000 p/year – 5 Years To Retirement

You will have paid off your mortgage in 5 years and will generate rental income from your basement suite to the tune of $1500.00 per month or $18,000 annually (this rental rate also grows with market inflation).

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).

Outcome: You will need to save $60,000 annually over the next 5 years to draw $12,000 of annual investment income. Combined with $18,000 annual rental income to fund your $30,000 p/year retirement.

The Bottom Line

By setting the goal of when you want to achieve Financial Freedom, 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 Financial Freedom.

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. Now all you have to do is make sure it’s achievable.

Which 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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