Why Does Your FI Ratio Need To Be More than 100%?

The one issue with running a personal finance blog is that I think about personal finance, A LOT! With the arrival of WB40 Junior, the one question that has been bugging me lately is:

How much capital do I need to stop working tomorrow?

This has been an entire hypothetical exercise because I really do enjoy my work and the prospect of being a 24/7 stay-at-home-dad does not appeal to me. Plus my job is fairly flexible and autonomous so I can dictate much of my schedule. However I just really want to know my Financial Independence (FI) number!

The FI Ratio

FI number is the target you need to be able to retire tomorrow.

To know my FI number, I must first define what financial independence means to me. There are various qualitative definitions of FI which you can read here. All of them provide great motivation during this amazing journey.

Quantitatively, the best definition I’ve read is provided by Joe from RetireBy40. He examined 3 approaches and examined the pros and cons of each:

  1. Net worth
  2. Cash Flow
  3. Mix and match of #1 and #2 -> as long as income is derived from non-employment sources

Personally, financial freedom means our living expenses are covered by income derived from passive sources (i.e. #2 of Joe’s method) because it literally means I am no longer dependent on any earned income.

FI Ratio = Passive Income  / Living Expenses

I really like this concept for 2 reasons:

  1. Logical: the formula sums up FI beautifully. Once my passive income exceeds my expenses, then I no longer need paychecks from an employer to function in this world. Any earned income would be incremental and it would be there because I wanted to rather than needed.
  2. Simplicity: this is a ratio that can be universally understood and widely accepted, which makes it powerful.

My current FI Ratio

So armed with the newly acquired FI knowledge and feeling all-powerful (after all knowledge is power), I did some simple arithmetics and worked out what my FI ratios have been so far this year.

The methodology I used is simple:

  • Income: I added up all of my after-tax passive income for each month (i.e. rental, dividend, interest from deposits).
  • Expenses: I then looked at my bank statements and broke down every transaction into 2 camps:
    • Fixed expenses: mortgage repayment, property tax, insurance, utilities, fixed loan repayments (on 2 pieces furniture at 0% APR) etc. These are essential living costs and they came up to £1,850 per month.
    • Variable expenses: I have a credit card which I use for my day-to-day shopping and other expenses. The amount is variable and I averaged £1,400 per month so far in 2018.

Once the data has been collected, I performed a quick calculation using the FI Ratio formula above to work out my FI number.

The danger of being content with FI Ratio = 100%

When the results came out, I was ecstatic. 3/5 months this year I was 90% or more in my FI Ratio. Maybe I should just quit working tomorrow, go to Chiang Mai like Jason at MrFreeAt30 and sip margarita all day long with Mrs. WB40 and WB40 Junior. After all, our living expenses are covered by our passive incomes.

Then I realized the flaws in my thinking.

Being content with a 100% FI Ratio is a slippery slope.

1. Time is your worst enemy when you’ve hit FI Ratio

This sounds counter-intuitive because we have all been indoctrinated into thinking that time is our best friend in investing.

The reality of immediately quit working after hitting your FI Ratio is that you’ll have an abundant amount of time on your hands. What people tend to do to kill time is to seek out novel experiences (e.g. shopping, dining out, traveling), all of which cost money.

Compounded by the fact that your mental state will be more relaxed than usual, it means that your tendency to spend is likely to be higher. As a result, expenses that seemed to be so low before may not be so after retirement.

Unconvinced? I spent 2 months in a state of early retirement right after graduating from university (until my first proper job). My rental income was sufficient to cover my living expenses every month with some change. And I can tell you I was bored to death.

What did I do? I spent extra money on going out with friends, making short weekend trips and generally messed about. Towards the end of that 2-month, my bank balance definitely took a hit for the worse!

2. Inflation eats away your FI Ratio

If your passive income is inflation-proof (e.g. index-linked bonds, certain real-estates or above-inflation-yielding equities) then good on you, you have inflation-proofed your FI journey. Ignore this section.

Yet for most of us mortal souls, inflation is real and it chips away our capital at around 3% per year (measured by CPI). Our ability to raise passive income may be limited. If you own a rental property in a market downturn then not only will you not be able to beat the CPI, you’d be lucky to get a rent-paying tenant! Equally, if you own a high-yielding stock during a recession then your income may be slashed as the company could ill-afford to be generous with its profit distribution.

Meanwhile, inflation is still charging at you like a bulldozer, eating away your FI Ratio and places you under financial strain, which brings me nicely onto my 3rd point.

3. 100% FI Ratio doesn’t offer much margin of safety

Imagine if you normal living expenditure is at £2,000 per month and you bring in an equivalent amount of passive income. You’ve technically reached 100% FI. Time to retire, right?

Well, what happens

  • If your boiler breaks down?
  • If you missed your flight and had to buy a new ticket?
  • If you were sick and needed specialist treatment?

These are all legitimate common life events that bear real costs. They have all happened to me personally before. Suddenly you realize that 100% FI Ratio is no longer sufficient and you don’t have that steady paycheck to fall back on. This means making difficult trade-offs, which is never pleasant (e.g. your money or your health). Alternatively, you could liquidate some of your investment but that would eat into your capital level, reducing future passive income.

The margin of safety (MoS) concept was initially a stock picking approach proposed by Benjamin Graham (Warren Buffett’s mentor). The central thesis is that the steeper the price discount versus the intrinsic value, the greater the upside gain there is and higher safety margin the investment offers. This is essentially the antithesis of error margin.

When applied to the FI Ratio and combined with the scenarios above, having a margin of safety is a great idea.

Imagine if you applied a 50% MoS, so your FI Ratio is 1.5. This means your monthly passive income is £3,000 versus the £2,000 expenditure. Suddenly you no longer had to endure the dark wintery nights in a freezing house when that boiler breaks. You could splash on the latest energy-saving model.

The key to maintaining a good Level of MoS is that it can accommodate unexpected expenses as well as handling change in lifestyle circumstances. Taking my situation as an example:

  • With the arrival of WB40, my fixed expense will increase by at least £1,500 per month (83%!!).
  • This is because childcare is extremely expensive in developed countries and I want (not to be confused with need) external help to save time and brain space so that I can focus on creating more passive income.
  • This will reduce my FI Ratio from an average of 90% per month currently to 55% per month.
  • Having a 50% MoS (i.e. FI Ratio = 140%) would have been very handy right now!

Even if you don’t have kids and have very low maintenance requirement, the MoS will give you additional cushion every month to stash it away for a rainy day (or be invested to generate additional income down the line).

Wrap up

I really like the FI Ratio concept. I think it is logical and simple, which makes it powerful.

However, I believe that being overly fixated on achieving 100% FI or being content with it can be dangerous because it doesn’t offer much room for error. Instead, I aim to overshoot it by at least 25% (ideally 50%) so that I can maintain a good MoS to weather most things life throws at you.

What is your FI Ratio? I would love to hear your thoughts on this. As usual, please comment away.