Rohit – You know what, I don’t think I can retire early. I think only people who earn more than Rs. 1 crore can retire early. This is not just the story of Rohit but of countless people I have spoken with. What people fail to understand is that income is the least important thing for financial independence, it is your expense that determine everything. Reasons being : a) Lower expense mean a higher savings rate and b) Lower expense mean that you need a much smaller retirement portfolio (since you can live by spending less). I have talked about it more in my post here. If your income is above a minimum amount then income doesn’t matter for financial independence.
But today let us use mathematics to prove that expense is more important than income for financial independence.
Using mathematics to prove why income doesn’t matter
You might have heard about the 4% safe withdrawal rule, if not read about it in my post here. Idea is that to be financially independent 4% (or whatever it is for you) of investment/retirement portfolio (P) must be enough to cover expenses (E).
Hence, 4% x P = E or 0.04 x P = E
Suppose income is represented as I and savings rate (i.e. savings/income * 100) as S, then: E = I x (1-S).
But we already know that E = 0.04 x P.
Hence, 0.04 x P = I x (1-S)
Now, we know that P or total retirement portfolio is nothing but total money saved + interest amount. Hence, P = Income (I) x Savings rate (S) x [((1+R)^N – 1)/R], where R is the returns and N is the number of years.
What we have then is : 0.04 x I x S x [((1+R)^N – 1)/R] = I x (1-S)
If you look at the equation carefully, you can see that I (income) on both left and right hand side cancel each other. Hence, we are left with the following:
0.04 x S x [((1+R)^N – 1)/R] = (1 – S)
Above equation proves that income on it own doesn’t matter. The saving rate is dependent more on how much you spend, rather than how much you earn. Reason being, that most of us don’t see a sharp increase in income (very rarely people who were earning Rs. 6 lakhs an year ago start earning Rs 1 cr). What happens in most of the cases is that our income increases gradually (10-20% per year) and more often than not our expenses increase in line (10-20%). This means that most of us are never increasing our savings rate even though income is increasing. Why, you ask. That is because we don’t follow the philosophy of buy what you need, not what you want.
To summarize, below is how savings rate (which essentially depends on your expense) affects your years to financial independence.