"We're flawed because we want so much more. We're ruined because we get these things and wish for what we had."

— Don Draper

 

I’ve been watching Mad Men—again. This is not my first, second or third time through. I’m a bit addicted. For those unfamiliar with the plot there are two underlying and related themes.

It is a story about broken people with a profound sense of loneliness that is tempered by the relationships they build with their colleagues.

And it is the story of Don Draper who is constantly running away and searching for something more, yet always drifting back to where he came from. Work is more than work. It represents the intersection of his talent, his ambition and sense of worth.

Naturally, this makes me think of the FIRE movement and the devotees who are willing to go to extreme measures to stop working.

The FIRE movement

For the uninitiated FIRE stands for financial independence, retire early. Describing it as a movement seems grandiose but temay not be too far from the truth.

It is hard to nail down exactly what the FIRE movement is because it has morphed in so many different directions. This is indicative of investors working to achieving their own goals. But the original concept involved living frugally to save and invest money until you reached a point of financial independence. Then you quit your job.

Conceptionally that sounds straight forward. And after a particularly hard day at work, it sounds appealing. I have mixed feelings about the FIRE movement. I’m a huge advocate for everyone to become financially independent. Yet I’m also concerned about some of the financial tenets of the group.

Below are the key steps of FIRE along with my thoughts and lessons that I think any investor can take.

Living frugally and saving lots of money

FIRE advocates extreme savings rates. Hence the emphasis on frugality. It is not uncommon to see suggestions for savings rates of upwards of 50%.

These levels of savings are needed for the math to work. To retire decades early you need to save significant amounts of money. This is obvious.

How much you need is a function of how much you plan to spend each year in your early retirement. And by saving an extreme amount of money your spending needs are lower.

I’m all for sacrificing for a better future. And I don’t think that most people save enough money. At the same time I think that each of our lives come down to the experiences that we manage to accumulate. Some of those experiences are free. Some cost money.

The important lesson I think each of us can take from the FIRE movement is being cognisant of the impacts of lifestyle creep. This is something I think about a lot. Please excuse a minor digression. I promise this will make sense.

Daniel Kahneman and Amos Tversky were two psychologists who examined human behaviour and created the field of behavioural finance. Over decades they studied how we make decisions and changed the prevailing view that people did a good job making the right decisions to maximise utility. In a financial context they debunked the notion that people rationally sought to maximise their net worth.

They ran a series of experiments framing a choice as an opportunity for a gain. Then they reversed the framing so instead people were avoiding a loss. People ended up making different decisions based on the framing. It turns out that we don’t maximize utility. We seek to minimise regret. 

This had a lot of implications on investing but it also provides some insights into the issue with lifestyle creep and our struggles with saving money. We all might yearn for more. But our happiness is impacted to a greater degree by giving stuff we have up. That is where regret comes in. 

This brings us back to lifestyle creep. As we earn more money we tend to mindlessly increase our lifestyle. It might be getting coffee at a café instead of making it ourselves. It might be an annual vacation, a nicer place to live or a nicer car. We may say we don’t care about these improvements to our lifestyle. But we have a really difficult time giving them up. To conciously decide at a certain point in your life to give something up to save more money is hard. It is easier if you never get used to something in the first place. 

I have no interest in living my life under self-induced extreme frugality. Yet I am very cognisant of lifestyle creep. As I look to the upcoming tax cuts I will do what I’ve done with increases in my pay in the past. I will spend some of the tax cut since absolutely everything has gone up in price. But I will also save some of the extra money to guard against lifestyle creep.

The biggest impact of lifestyle creep is when we increase spending on our largest expenses. For most people that is housing. We all need to be especially vigilant about lifestyle creep with our largest expenses.

There are lots of people who make high salaries and live paycheck to paycheck. Despite their earning power they have little chance of ever achieving financial freedom and suffer the same stress as people who barely earn enough to pay for necessities.

Even if you don’t want to live in extreme frugality you can learn from the FIRE movements emphasis on spending. Saving more, spending less – just two sides of the same coin.

Getting to your FIRE number

Living a frugal lifestyle and saving lots of money has a purpose. The goal is to get to your FIRE number. That is the amount of money that enables financial independence by allowing a FIRE devotee to quit their job.

The most common guidance on calculating a FIRE number is to take annual spending needs and multiple it by 25. I don’t think this is a great approach for most people. More on that later. I will start with the positives.

The typical approach to retirement – early or otherwise – can be summed up in one word. Procrastination. People typically drift through life with no idea how much is needed for retirement.

Without a goal in mind there is no way to assess if you are on track or off-track for retirement. Without a goal there is no way to know how much to save and what kind of investments should be in your portfolio. 

I think one of the things we can all learn from the FIRE movement is to come up with a retirement number. It can change over time as circumstances change but setting the goal is the first step to taking control of your financial outcomes. If you want to estimate how much you need for retirement i've outlined the process in this article. 

Now to the part of the FIRE movement that concerns me. I think a little more nuance needs to be taken in setting a FIRE number.

The 25 times annual spending was taken from the 4% rule. Multiplying something by 25 is mathematically equivalent to dividing by 4%.

I won’t go into all the nuances of the 4% rule but you can read more about it in this article. It is important to note that 4% was designed to account for the risks that impact retirees – poor returns at the beginning of retirement, high inflation and the risk that you live longer than expected.

The 4% rule also assumes a 30-year retirement time horizon. That makes sense if you retire at 65 as most people will die by 95 years old.

Ultimately withdrawing 4% a year from your portfolio accounts for the risks that all retirees face when you are trying not to run out of money over a 30-year time frame. The picture looks a little different for longer retirements.

The ‘early’ in FIRE is not defined. Adherents are just told they can retire as soon as they hit 25 times their annual spending. Perhaps everything will go right and markets will surge right after retirement, inflation remains low and death occurs closer to the average lifespan. But the longer you are asking a set amount of money to last the higher the risk.

To use the same rule of thumb for somebody retiring early at 45 and early at 57 makes no sense. The earlier your retirement the lower the withdrawal percentage should be. At a more conservative withdrawal rate of 3% an early retiree would need more than 33 times annual spending to hit their FIRE number.

There are other ways that personal circumstances impact a FIRE number. We tend to think of inflation as something that impacts everyone equally. That isn’t true. If you own your house outright inflation will have less of an impact on your spending. Higher interest rates won’t increase your mortgage costs. Higher rents will have no impact on you. The key is working out your personal inflation rate.

Then there are taxes. A simplistic view of 25 times your spending needs doesn’t account for the differences in the tax status of your investments. We can take a hypothetical investor trying to retire early. Spending needs are $50,000 a year and the investor reaches their FIRE number of $1,250,000. $750,000 is in super and $500,000 outside of super.

Aggregating those two balances together to reach a FIRE number is not realistic because in a practical sense they are different amounts. Capital gains taxes will have to be paid on the non-super assets. Taxes on dividends will detract from returns. No taxes will be paid on the super assets if they are in a pension account when the investors reaches preservation age.

If assets generate capital gains in the non-super accounts the investor will either have less than $50,000 to spend or more will have to be withdrawn to pay taxes while keeping $50,000 left over to pay for living expenses. The point is that the same assumptions can’t be made across retirement and non-retirement assets.

Maybe this sounds like nitpicking. Perhaps I am taking something easy – amass 25 times your spending needs and retire at any age – and making it hard. But it is hard. Figuring out a safe withdrawal rate is hard. Incorporating your personal inflation rate into withdrawal rates is hard. Taxes are complex.

Final thoughts

The FIRE movement is easy to mock. The stereotype is a bunch of people living in rented granny flats eating instant ramen. And they are doing this because they want to quit work and spend the rest of their life living in a rented granny flat eating instant ramen.

There is the notion that FIRE is only for people that make high salaries because who else can afford to save such a high percentage of their salary and still survive.

All of this is partially true. But I think there are admirable things about FIRE. Afterall financial independence is empowering. And it doesn’t have to be the ability to quit your job. Financial independence is not a destination but a series of steps.

An emergency fund provides freedom from the usurious rates charged for consumer credit. Having some money tucked away provides freedom from abusive partners and protects us from the debilitating stress of living paycheck to paycheck. Working towards financial freedom can change lives even if you work to 65.

The FIRE movement is all about setting and achieving a goal. And goals matter. Most investors don’t bother to set them. Even if the goal can’t be achieved the journey improves outcomes.

FIRE is about using financial assets to create a desired outcome. This is an important lesson. Our financial assets should be used to support the lives that we want to live. Most of the discussion about investing is about dollars and cents. But it is more than. Our portfolios are not numbers on a website. They are the embodiment of our hopes and dreams.

And this concept is at the core of FIRE. Retiring early isn’t really about quitting a job. It is about freeing up time to do what people love.   

Don Draper’s futile attempts at a new beginning and his ability to re-engage in his life with few consequences are facilitated by his talent and his wealth. While financially independent, he thrives under the pressure of the next challenge too much to bow out and retire. But he has nonetheless created freedom for himself to figure out how he pursues life even if he remains employed. And that is what we all want. 

In the spirit of helping people live their dreams I don’t want to be another FIRE naysayer. I want to provide my own view of how to achieve FIRE and a spreadsheet for people to design their own plan. I will publish that in part 2.

I would love to hear your thoughts. Email me at mark.lamonica1@morningstar.com  

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