Financial independence is great. But sometimes it can be daunting. Personal finance itself can be daunting, and now we’re adding something called financial independence or “FIRE” to it?
I decided it was time to come up with an approachable, understandable, and cost free entry point into financial independence. With the four resources listed below, I believe one can rather quickly get up to speed without needing any sort of advanced knowledge or education. The four resources, including one podcast episode, one very short academic article, and two blog posts, are free and easy to digest.
ChooseFI Episode 100: Welcome to the FI Community
This podcast episode goes over the basics of financial independence.
The Shockingly Simple Math Behind Early Retirement by Mr. Money Mustache
This blog post discusses the math behind early retirement.
The Arithmetic of Active Management by William F. Sharpe
This very brief academic article compares active investing versus passive investing (generally speaking, index funds).
FI Tax Strategies for Beginners by Sean Mullaney
My blog post goes over the basic tactics of tax planning for FI beginners.
Obviously there are plenty more FI resources, and I encourage you to explore them. But my hope is that these four resources comprise a relatively easy on-ramp into financial independence and personal finance for those starting out.
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, medical, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, medical, and tax matters. Please also refer to the Disclaimer & Warning section found here.
You know what doesn’t get enough coverage in the personal finance space: Medicare! It’s complicated, and frankly, I have neither the time nor the mental bandwidth to become a Medicare expert.
However, recently I have seen some excellent YouTube Videos on the topic. I believe all the links provided below are worthy of consideration. That consideration should, of course, include critical analysis: these videos are great, but they didn’t come down the mountain with Moses (neither did any of my blog posts or YouTube videos).
Further, none of the videos should be relied upon as advice for any particular person. They are all educational resources.
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, investment, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Decisions you make today can subject you to more inflation tomorrow! Read below about ways to increase or decrease your exposure to inflation tomorrow.
Watch me discuss fighting back against inflation.
Tax Planning
As a practical matter, most Americans have the majority of their retirement savings in traditional, pre-tax vehicles such as the 401(k). Having money in a traditional 401(k) is not a bad thing. However, the traditional 401(k) involves trade offs: an upfront tax deduction is the primary benefit in exchange for future taxation when there is a withdrawal or Roth conversion.
Having money inside traditional retirement accounts subjects future inflation to taxation. Some of the future growth in a traditional retirement account is likely to be attributable to inflation, and thus there will be a tax on inflation. Further, there are no inflation adjustments when it comes to the taxation of traditional IRA and traditional 401(k) withdrawals.
An antidote to this problem is the tax free growth offered by Roth accounts and health savings accounts. Getting money into Roths and HSAs excuses future growth from taxation, including growth attributable to inflation.
Roth 401(k) versus Roth IRA
Of course, inflation is only one consideration. Many will do some traditional retirement account contributions and some Roth retirement account contributions. The question then arises: which Roth account to use?
My view is that for many a Roth IRA contribution (whether a direct annual contribution or a Backdoor Roth IRA) is better than a Roth 401(k) contribution. Many do not qualify to deduct a traditional IRA contribution but can deduct a traditional 401(k) contribution. Considering that reality, why not combine a deductible traditional 401(k) contribution and a Roth IRA contribution?
Long Term Fixed Rate Debt
Often we discuss how inflation hurts Americans, and we should be concerned about the bad effects of inflation. However, there is a way to become a beneficiary of inflation: using long-term, low interest fixed rate debt to your advantage.
That’s right: hold onto that low rate 30 year mortgage like it’s a life raft! Okay, that’s a bit hyperbolic, but the overall point holds. Inflationary environments are great for debtors, particularly those debtors who have locked in a low interest rate for a long term.
Here is an example: Sarah and Mike have a 30 year, $400,000 mortgage on their primary residence at a 2.9% fixed interest rate. By paying the required monthly payment, and no more, they benefit from any future inflation. By paying off the mortgage later rather than sooner, they are using devalued future money to pay the mortgage rather than more valuable current day dollars.
Sarah and Mike benefit from inflation! Are there reasons to pay off a mortgage early? Sure. But in an inflationary environment, paying off the mortgage early gives the bank more valuable dollars to satisfy the debt.
To my mind, a fixed rate, long term mortgage is a great hedge against inflation.
That said, there are few perfect financial planning tactics. Most involve risk trade offs. One risk Sarah and Mike assume by not paying down the mortgage early is the risk of deflation. To obtain this inflation hedge, they expose themselves to the risk of deflation. If the U.S. dollar starts to deflate (i.e., it appreciates in value), Sarah and Mike will find themselves paying more valuable dollars to the bank in the future.
Travel Rewards
Travel rewards can help fight inflation. One way is using sign-up bonuses and other accrued points to pay for hotel room nights or flights. Using points gets out of cash paying and thus inflation of the dollar hurts a bit less.
However, keep in mind that travel reward points are subject to their own inflation! The hotel chain or airline can devalue the redemption value of points at any time. Thus, if everything else is equal, those with significant travel rewards point balances might want to spend those points sooner rather than later for travel.
A second consideration are the features of credit cards. Some travel branded credit cards come with certificates for free nights or a companion pass for a companion to receive free or discounted flights. If flighting inflation is a key goal, favoring cards that offer free-night certificates or companion passes can be a way to fight inflation.
Spending that Leads to More or Less Future Spending
We’re used to assessing the price tag. $28,000 for that brand new car: “that’s a great deal!” or “that’s a terrible deal!” But the price tag is only one part of the financial picture.
If you buy a black cup of coffee at Starbucks, it might cost you $2.65. Fortunately, that’s it. The cup of coffee isn’t likely to cause you to incur later costs.
What about a $45,000 SUV? That purchase will cause later costs, many significant. For example, the cost to insure a $45,000 SUV might be significantly more than insuring a $22,000 sedan. What about gas? By purchasing a larger, less fuel-efficient car, you lock in more future spending, and thus more exposure to future inflation.
Think about buying a large home with a pool in the backyard. That square footage attracts property tax, heating and cooling costs, and inflation in both costs. The pool in the backyard requires constant upkeep, subjecting the homeowner to another source of inflation.
To my mind, food is a big one in the fight against inflation. What you eat today could very well translate into medical costs tomorrow, exposing you to significant inflation. Spending on foods with vegetable oils and sugars today is likely to increase your future exposure to medical expense inflation.
The lesson is this: you can use today’s spending to reduce your exposure to future inflation.
Conclusion
Is there a perfect answer to inflation? No. But with some intentional planning and spending today, Americans can reduce their exposure to the harmful effects of future inflation.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Worried about an early retirement based on the Four Percent Rule? Might the 4% Rule work because of natural backstops most early retirees enjoy?
The 4% Rule
The 4% Rule is a rule of thumb developed by the FI community. For example, JL Collins writes extensively about the 4% Rule in Chapter 29 of his classic book The Simple Path to Wealth.
Boiled down, the rule of thumb states that an investor can retire when he or she (or a couple) has 25 times their annual expenses invested in financial assets (equities and bonds). They would then spend down 4% of their wealth annually in retirement. The first year’s withdrawal forms a baseline and is increased annually for inflation.
The idea behind the 4% Rule is that the retiree would have a very strong chance of funding retirement expenses and never running out of money in retirement. As a result, some refer to 4% as a safe withdrawal rate.
Here’s how it could look:
Maury is 50. He has $1M saved in financial assets. He can spend $40,000 in the first year of retirement. If inflation is 3% at the end of his first year of retirement, he increases his withdrawal by 3% ($1,200) to $41,200 for the second year of retirement.
The 4% Rule has a nice elegance to it. Most investors aim for a greater than 4% return. In theory, with a 5% return every year, the 4% Rule would never fail a retiree. If you spend approximately 4% annually, and earn approximately 5% annually, you have, in theory, created a perpetual money making machine and guaranteed success in retirement.
Watch me discuss the Four Backstops to the 4% Rule
The theory is great. But in practice we know that investors are subject to ups and downs, gains and losses. What happens if there is a large dip in equity and/or bond prices during the first year or two of retirement? What if there are several down years in a row during retirement?
As a result of these risks, and stock market highs in late 2021, some are worried that the 4% Rule is too generous for many retirees. Christine Benz discussed her concerns on a recent episode of the Earn and Invest podcast.
This post adds a wrinkle to the discussion: the four backstops to the 4% Rule for early retirees. What if worries about the adequacy of the 4% Rule for early retirees can be addressed by factors outside of the 4% Rule safe withdrawal rate? And what if those factors quite naturally occur for early retirees?
Resources for the Four Percent Rule
These are links to articles addressing the 4% Rule and safe withdrawal rates
Below I discuss what I believe to be the four natural backstops to the 4% Rule.
Spending
A 4 percent spending rate in retirement is not preordained from on-high. Spending in retirement can be adjusted. Those adjustments can take on two flavors.
See that the stock market is down 10 percent this month? Okay, take a domestic vacation for 6 days instead of an international vacation for 9 days. Buy a used car instead of a new car. Scale down and/or delay the kitchen remodel.
There are levers early retirees can pull that can help compensate for declines in financial assets while not too radically altering quality of life.
The second flavor is, from a financial perspective, even better. As early retirees age, there will be natural reductions in spending. How many 80 year-olds decide to take a 12 hour flight to the tropics for the first time? There is a natural reduction in energy and interest in certain kinds of spending as one ages. It is likely that many retirees will experience very natural declines in expenses as they age.
Social Security
For the early retiree under 62 years old, the 4% Rule must disregard Social Security. Why? Because Social Security does not pay until age 62, and many in the financial independence community delay Social Security payments beyond age 62, perhaps all the way to age 70 (to increase the annual payment).
Here is an example of how that works.
Melinda is 55. She has accumulated $1.5M in financial assets and can live on $60,000 per year. If she retires at age 55 and lives off $60,000 a year increased annually for inflation, the only financial resources she has are her financial assets (what I refer to as her 4% assets). She cannot live off Social Security payments until age 62, and may choose to defer receiving Social Security up to age 70.
If Melinda defers Social Security until age 70, and receives $2,500 per month at age 70 from Social Security, her 4% assets now do not need to generate the full 4% once she turns 70, since Social Security will pay her $30,000 a year at age 70.
In theory, under the 4% Rule, Melinda’s Social Security is play money. Melinda funds her lifestyle with withdrawals from her financial assets, and now she’s getting additional Social Security payments. But, if her portfolio is struggling to produce the amount Melinda needs to live off of, Social Security payments provide a backstop and can help make up the difference.
You might think “but wait a minute, didn’t Melinda significantly lower her Social Security benefits by retiring early by conventional standards? The answer is likely no, as I described in more detail in my post on early retirement and Social Security. First, only the 35 highest years of earnings count for Social Security benefits. At age 55 is it possible Melinda has 35 years of work in.
Second, and more importantly, Social Security benefits are progressive based on “bend points.” The first approximately $12,000 of average annual earnings are replaced by Social Security at a 90 percent rate. The next approximately $62,000 of average annual earnings are replaced by Social Security at a 32 percent rate, and remaining annual earnings are replaced at a 15 percent rate. This is a fancy way of saying that reducing later earnings, for many workers, will sacrifice Social Security benefits at a 15 percent, or maybe a 32 percent, replacement rate. Even early retirees are likely to have secured all of their 90 percent replacement bend point and a significant amount of their 32 percent replacement bend point.
Chuck is 55 years old and has 32 years of earnings recorded with Social Security. Those earnings, adjusted for inflation by Social Security, total $2,800,000. Divided by 35, they average $80,000. This means Chuck has filled the 90 percent replacement bend point (up to $12,288) and filled the 32 percent replacement bend point (from $12,288 to $74,064) of average annual earnings. If Chuck continues to work, his wages will be replaced at a 15 percent replacement rate by Social Security.
An additional year of work for Chuck at a $130,000 salary netted Chuck only $557 more in annual Social Security benefits at full retirement age!
Real Estate
Most early retirees own their own primary residence, usually with either significant equity or no mortgage. That primary residence can be a backstop to the 4% Rule.
For example, a retiree might live in a 2,000 square foot, $500,000 home with no mortgage. During their retirement, they might decide they don’t want to maintain such a large home, so they sell the 2,000 square foot home and move into a 1,000 square foot condominium at a cost of $350,000. The $150,000 difference in sale prices can become a financial asset to backstop 4% Rule assets and help the retiree succeed financially.
Alternatively, the early retiree could sell the $500,000 home and move into a smaller apartment with a $2,000 per month rent. While the retiree has increased their expenses, they also have created $500,000 worth of financial wealth to help pay that rent and fund their other expenses.
A third option is a reverse mortgage where the retiree stays in their primary residence but gets equity out of the home from a bank.
Real estate can serve as a natural backstop to help ensure retirees have financial security and success.
Death
It’s wet blanket time. You may be considering a 30, 40, or 50 year retirement. Unfortunately, there is a good chance that you will not live that long. Sadly, not all early retirees have a long retirement.
As demonstrated in these tables, there is a real chance that an early retiree will not live for 25 or 30 years. That factors into whether or not the 4% Rule will work for an early retiree.
Let’s consider a 55 year old considering early retirement using the 4% Rule. He believes that he will live 30 more years and there is a 95% chance that his assets will last 30 years. He believes that the 4% Rule has a 5% chance of failing him. Further, assume that he believes there is a 30% chance that he will die prior to age 85.
His own potential death reduces the chance that the 4% Rule will fail. Remember, failure requires that he has to both run out of assets and live long enough to run out of assets. By his estimation, the odds that both events will occur are just 3.5 percent. To figure this estimated probability, multiply the probability that he will run out of assets (5%) by the probability that he will live long enough to run out assets (70%).
A not insignificant number of early retirees will have an early retirement that lasts (sadly) only 10 years, 15 years, or 20 years. That (again, sadly) backstops the 4% Rule.
Early Retirees vs. Conventional Retirees
I’ve contended that early retirees have four natural backstops to the 4% Rule. What about more conventional retirees? I’ll define a “conventional retiree” as one who collects Social Security soon after retiring.
I believe conventional retirees enjoy three of the four backstops. Sadly, they “enjoy” the mortality backstop to a greater degree than early retirees.
Conventional retirees retiring on Social Security do not enjoy Social Security as a backstop to the 4% Rule in most cases. Here’s an example:
Robert is age 65 and is planning to retire on financial assets and Social Security. He will collect $36,000 a year in Social Security and will spend a total of $76,000 a year. To facilitate this, he will initially withdraw $40,000 from his $1M portfolio.
In Robert’s case, Social Security is not a backstop to the 4% Rule. Rather, the 4% Rule is simply one of two necessary but not sufficient sources of funds for his retirement. A failure of the 4% Rule in Robert’s case would not be backstopped by Social Security.
Conclusion
While there are no guarantees when it comes to safe withdrawal rates in retirement and the 4% Rule, it is possible that many early retirees will succeed with the 4% Rule, for two reasons. First, the 4% Rule may, by itself, be successful for many early retirees. The second reason is that even if the 4% Rule fails, there are four natural backstops in place for many early retirees that can step in and help retirees obtain financial success even if the 4% Rule fails on its own.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
UPDATE October 20, 2023: This post has been updated for the 2024 Social Security numbers.
I can’t retire early! I’ll destroy my Social Security!
Is that true? What happens to Social Security benefits when retirees retire early? Are significantly reduced Social Security benefits a drawback of the financial independence retire early (FIRE) movement?
Below I explore how Social Security benefits are computed and the effects of retiring early on Social Security.
Social Security Earnings
Form W-2 reports to the government one’s earnings during the year. For the self-employed, the Schedule SE performs this function. The Social Security Administration tracks those earnings.
Only a limited amount of earnings every year count as Social Security earnings. There is an annual maximum on the amount of earnings that can go on one’s Social Security record, regardless of the number of jobs one has. For 2024, the Social Security cap is $168,600. The cap is increased most years for inflation. Payroll taxes for Social Security (FICA for W-2 workers, self-employment taxes for the self-employed) are not due on earnings above the cap.
Social Security Benefits
A few very general rules need to be established as we consider the amount Social Security pays.
Only the highest 35 years of earnings during one’s working years count in determining Social Security benefits.
For most Americans reading this, full retirement age is 67. This means a person can collect his or her “full” Social Security benefits at age 67.
Social Security benefits can be collected as early as age 62 and can be deferred as late as age 70. Collecting early reduces annual benefits (by roughly 5 to 7 percent per year) and collecting late increases benefits (by 8 percent per year).
Very roughly speaking, the annual benefit is computed as follows: accumulated earnings (computed based on the rules described above) in the high 35 years are summed and then divided by 35. The resulting average annual earnings are applied against the Social Security “brackets” or “bend points.” Up to $14,088 (using 2024 numbers) of computed average annual earnings is replaced by Social Security at a 90% rate. The next $70,848 of average annual earnings are replaced at a 32% rate. Any additional amount of average annual earnings is replaced at a 15% replacement rate. The bend points are adjusted for inflation.
One need not be an expert on Social Security to see directionally how early retirement might impact Social Security benefits. Because of the progressive nature of Social Security benefits, leaving work early (by conventional standards) tends to reduce benefits less than one might initially expect. Additional earnings later in life tend to only slightly increase Social Security benefits.
Early Retirement Social Security Example
Here’s an example to help us understand the impact of an early retirement on Social Security benefits.
Chuck is 55 years old and has 32 years of earnings recorded with Social Security. Those earnings, adjusted (thus, nominally increased) for inflation by Social Security, total $3,100,000 as of 2024. Divided by 35, they average $88,571. This means Chuck has filled the 90 percent replacement bend point (up to $14,088) and filled the 32 percent replacement bend point (from $14,088 to $84,936) of average annual earnings. If Chuck continues to work, his wages will be replaced at a 15 percent replacement rate by Social Security.
If Chuck retires now and earns nothing more, his annual Social Security benefits, expressed in 2024 dollars, will look something like this at full retirement age:
Replacement Rate
Replaced Annual Income
Annual Social Security at Full Retirement Age
90%
$14,088
$12,679
32%
$70,848
$22,671
15%
$3,635
$545
Total
$88,571
$35,896
Note that I rounded each bend point’s calculation. With the cents Chuck gets in each bend point, his total is increased by almost a full dollar. Similar rounding applies to the examples below as well.
At age 67, Chuck’s annual Social Security will be $35,896 (expressed in 2024 dollars).
If Chuck continues to work for one more year at a $130,000 salary, and then retires his annual Social Security benefits at full retirement age, expressed in 2024 dollars, looks something like this:
Replacement Rate
Replaced Annual Income
Annual Social Security at Full Retirement Age
90%
$14,088
$12,679
32%
$70,848
$22,671
15%
$7,349
$1,102
Total
$92,285
$36,453
Interestingly, an additional year of work only increased Chuck’s annual Social Security benefit by $557. Why is that? Remember that every dollar earned is divided by 35 for purposes of computing Social Security benefits. You can see that Chuck’s replaced income increased by $3,714 (from $88,571 to $92,285). By earning $130,000 in 2024, Chuck increased his Social Security average annual income by $3,714, which is $130,000 divided by 35.
Multiplying the increase in replaced income ($3,714) by the replacement rate (15%) gets us the additional $557 in annual Social Security benefits.
Okay, but what about three more years of earnings. Say Chuck can work for three more years at an average annual salary of $135,000. What result (in 2024 dollars) then?
Replacement Rate
Replaced Annual Income
Annual Social Security at Full Retirement Age
90%
$14,088
$12,679
32%
$70,848
$22,671
15%
$18,920
$2,838
Total
$103,856
$38,188
Where I come from, $1,735 ($38,188 minus $36,453) in increased annual Social Security benefits at full retirement age is not nothing. But is it worth delaying retirement for three full years if one is otherwise financially independent? To my mind, probably not.
Spousal Benefits
What if Chuck is married to Mary? How does that impact the analysis?
During Chuck and Mary’s joint lifetimes, it depends on whether Mary collects spousal benefits. If Mary has Social Security earnings of greater than 50 percent of Chuck’s Social Security earnings, she will likely collect benefits under her own earnings record, and not a spousal benefit. Thus, Chuck’s Social Security earnings will be irrelevant to the Social Security benefit Mary collects.
If, however, Mary’s lifetime Social Security earnings are less than 50 percent of Chuck’s, Mary is likely to collect a spousal benefit of roughly half of Chuck’s annual benefit. In this case, Chuck working 3 more years creates $2,603 of additional annual Social Security income ($1,735 for Chuck and $868 as Mary’s spousal benefit). Even $2,603 in additional annual income isn’t likely to justify Chuck working for three more years.
At Chuck’s death, assuming Chuck predeceases Mary, Mary will collect the greater of her own Social Security benefit or Chuck’s Social Security benefit. Thus, Chuck increasing his Social Security earnings could increase Mary’s Social Security benefit as a widow.
Most people I know cannot tell you their Social Security earnings record off the top of their head. But, this information is accessible by creating an account at ssa.gov. From there, Americans can obtain their Social Security statement which includes their Social Security earnings (though the statement does not adjust those annual earnings for inflation). The 2024 factors to increase annual earnings for inflation can be found by entering “2024” in the search box at the bottom of this SSA.gov website.
Conclusion
There are many factors to consider before retiring early. It is helpful to understand how Social Security benefits are computed so early retirees can understand the potential impact of retiring on their Social Security benefits.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.
Recently, the FIRE movement has come in for some criticism. Here is one prominent example. While I don’t want to speak for the critics, some of the arguments boil down to a version of the following: FI or FIRE (I prefer FI, but let’s not argue over terminology) overemphasizes personal responsibility and individualism, as most financial outcomes are the result of luck and the work of others. For example, if you invest $250,000 in real estate and local property values skyrocket such that your investment is now worth $600,000, most of the value of your investment is not attributable to anything you did.
While I appreciate the perspective provided by these commentators, I respectfully disagree with the criticisms.
My Journey with FI
Before I address the criticisms, I thought it would be helpful to share a bit of my perspective on FI. My journey with personal finance mostly starts in college, when I began to become interested in some of the tactics of personal finance. Things like the Roth IRA and passive investing.
For me, the tactics were like the quartz countertops, cabinets, and ceiling beams on a home construction site: shiny objects drawing attention, but by themselves not all that impactful. As applied to personal finance, when you add in the FI framework, you transform shiny objects into a house. Having the FI framework and goals ultimately drives better choices and better luck.
Getting introduced to FI in 2017 flipped a switch for me. It gave meaning to the personal finance tactics. More important, it encouraged me to make better choices. For me, it’s not about a FI number or a retirement deadline.* And it has never been about anyone who retired at a particularly early age. Rather, to me FI is all about making better choices that give me and my family more options and better financial luck.
This is why I don’t believe “financial literacy” is an adequate substitute for FIRE. You can teach people about 401(k)s and HSAs until you’re blue in the face. Without something akin to the FI framework, financial knowledge by itself does not often materially improve choices and outcomes. Financial literacy without a framework and goals is sort of like teaching algebra in high school. There’s nothing wrong with it, but how much did algebra affect your adult life?
Having shared a bit of my own FI journey, here are my thoughts on the recent criticisms of the FIRE movement.
* Note: For some, FI is about hitting a FI number and/or retiring by a certain date. That’s great–to each their own.
The Role of Luck
Michael Jordan won six NBA Championships. Wouldn’t we all say that he was a great basketball player?
But wait a minute. Wasn’t almost all of his success attributable to luck? First, Dr. James Naismith invented the sport of basketball. Then players, promoters, and team owners spread the sport throughout the United States such that professional leagues could become a way to earn an income. Then the founders, players, coaches, owners, television executives, and fans of the National Basketball Association had to build it and sustain it through some very challenging times. Without the work and support of countless people, Michael Jordan would not have been able to make a living playing basketball, much less win six championships playing basketball.
And what about Jordan’s height, good health, parents, coaches, and teammates? Talk about lucky . . .
Most of us, when confronted with all the luck Michael Jordan had in his basketball career, would simply acknowledge that luck played a role, but that in no way diminishes all the hard work he put into his craft and the fact that he was a great basketball player.
In all situations, luck plays an important role. There is little anyone can do to avoid being subject to a significant degree of luck. All you can do is make choices based on judgment and what experience and history teach. Often, you will enjoy more good luck as you make better choices.
Luck and choices are not entirely unrelated. The better financial choices you make, the more likely it is you will have good financial outcomes and enjoy better luck along the way. For example, you can’t get lucky with an investmentif you don’t make the investment!
Investment growth could** be thought of as luck. But without an individual financial choice (the decision to invest), you get absolutely none of that luck! The FIRE movement simply says “we have hundreds of years of economic data: we know diversified baskets of productive investments generally tend to grow over long periods of time, so start investing!”
FI provides a framework for capturing financial luck. Why shouldn’t there be a “movement” (if you want to call it that) of people who are intentional about making better choices that increase the odds that they and others will experience financial luck and success?
** Note: I do not believe investment growth is luck. I simply acknowledge that some might think of investment growth as luck.
Credit versus Choices
The FIRE movement is not about claiming credit for financial outcomes. It’s about encouraging good financial choices.
To my mind, arguing that the FIRE movement is lacking because most of the credit belongs to others misses the point. The point of the Financial Independence movement is not to “deserve” financial success. Rather, the point is to make choices that increase the odds of financial success and having more financial options.
If I wear a seatbelt, I’m making a choice that increases my odds of staying safe.
I (hopefully) don’t demand credit for being safe. Rather, I simply make an informed choice that makes my life incrementally better.
That is what the FIRE movement is all about: make good choices in your financial life, and, generally speaking, your financial life tends to have good outcomes. If someone wants to give you credit for the resulting outcomes, that’s fine, but that credit is not what the FIRE movement is all about.
None of this makes financial independence easy, and financial independence as an end goal will be more difficult for some than for others.
But practically everyone has financial choices to make. Thus, the FIRE movement can speak to everyone. The FIRE movement offers a framework and encouragement to make good choices. Regardless of the luck you have had up to now, it is better to be intentional about your financial choices and seek to improve your future financial choices.
Room for Improvement
Is everything perfect in the FIRE movement? Surely not. For example, extreme examples of FIRE tend to get overemphasized in the media and within the movement (in my opinion).
Overemphasizing certain stories causes a distorted view of financial independence. But podcasts, YouTube, blogs, and other forums help all sorts of FI stories to get out there. The FIRE movement is constantly developing and different FIRE voices appeal to different listeners (and hopefully to a growing number of listeners).
My hope is that the movement and the media reduce the emphasis on some of the more extreme FIRE examples (while still acknowledging their validity) and choose to promote a diverse array of FIRE perspectives. No one has all the answers, but everyone can make a contribution.
FI/FIRE will survive out of economic necessity. What else are people to do? Tie their entire economic future to one job that can be gone in an instant? The economic downturn occurring due to Coronavirus demonstrates that you need multiple sources of economic support. Part of FI (or FIRE) is that you ultimately build up so many sources of support (essentially, a well-diversified portfolio) that your job becomes an unnecessary source of support.
I stand by that. Some argue that FIRE is unrealistic. I’d argue that tying your financial future to a single job (or, more broadly, to your ability to always earn an income from your labor) is unrealistic.
The FIRE movement provides a framework for improving your financial condition through better choices. That is a movement worth staying in.
FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
In the financial independence community and beyond, high deductible health plans (“HDHPs”) have received significant criticism. Few downplay the significant tax benefits of their tag-team partner, the health savings account. But some have written that the HSA sweetener is not sufficient to make high deductible health plans desirable.
Below I offer a different perspective. I write regarding the approach of anyone seeking financial independence, but I believe much of what is discussed below applies regardless of whether you are seeking financial independence.
One quick caveat: the below assumes that you are relatively healthy when you select your medical insurance, and that you expect that you will most likely remain so. For those with significant, chronic medical conditions, an HDHP is not likely to be a good medical insurance choice.
HDHP Critiques
High deductible health plans have been criticized by both the national media and by financial independence writers. Several studies have found that those covered by HDHPs tend to delay or forego needed medical assistance when compared with the population at large. This study found that those with HDHP insurance tend not to take advantage of free preventive services. Based on these study findings, there is a concern that the use of HDHPs can cause long term harm and worsen medical and health outcomes.
Financial Independence Mentality
Those actively seeking financial independence (“FIers”) embrace two beliefs. First, they believe they are not constrained by others’ failures. While FIers understand that others’ failures can be indicative of difficulties they themselves might face, FIers believe that with intentional action they can overcome those difficulties.
FI exists because people see what the “average” or “typical” person does (for example, a very low savings rate) and say, “wait a minute, I’m going to do something very different.” FIers acknowledge a societal trend and then pursue a different path with intention.
Second, FIers prioritize valuable purchases over immediate bottom-line results. Being financially independent (or seeking FI) frees you from the tyranny of any particular financial number when considering necessary expenses.
Health Insurance and Behavior
Your medical insurance should not determine whether you seek medical care. Only your current condition should determine whether you seek medical care. Assuming, only for the sake of argument, that the studies’ findings are correct, should those findings deter someone pursuing FI from using an HDHP as their medical insurance? I argue that they should not, for several reasons.
First, the studies probably did not include you. Why would you have a limiting belief about your own future behavior based on studies of other people? Even if you were in one of the studies and delayed or forwent necessary medical treatment, is it not possible that you could change your behavior?
Second, why not simply accept that cost will deter some people from obtaining needed medical assistance, but resolve that you will not act in such a shortsighted fashion. Many FIers seek to obtain financial assets of $1 million, $1.5 million, $2 million or more to fund the rest of their lives. Neither an unanticipated $300 medical expense nor an unanticipated $5,000 medical expense will derail your plans to achieve financial independence.
If you commit to FI, you are committing to acting very differently than most people when it comes to spending and saving. Why then would you believe you will act like the average study subject when it comes to obtaining medical treatment for a medical need?
Third, there is nothing preventing those with HDHPs from taking advantage of free preventive services. Many workers do not take advantage of the employer match to their 401(k). That outcome does not make a 401(k) a bad retirement plan. Rather, it illustrates that in many areas of life, people should be more intentional about taking advantage of what is offered to them. Suboptimal human behavior does not make 401(k)s and HDHPs bad, and others’ mistakes should not limit your insurance choices.
Finally, financial independence exists in part to make personal finances revolve around what needs to happen, and not to have what needs to happen revolve around personal finances. FIers ought to make medical care decisions based on their health, and not based on avoiding a medical bill that is ultimately minor in the grand scheme of things.
The Role of Insurance
What the studies appear to illustrate is a widespread misunderstanding of medical insurance. Insurance does not exist to determine whether you obtain medical assistance. Insurance exists to prevent financial ruin.
Might an unexpected medical situation be expensive if you have an HDHP? Yes, absolutely. But should it be ruinous? It should not be. Your annual out-of-pocket maximum for medical expenses will be high: imagine in your mind’s eye that it is $10,000. In the event of a medical calamity, you will pay $10,000 in expenses annually. Then your finances are protected.
Does an unexpected $10,000 expense hurt? Absolutely. But if your FI plan was to build $1.5 million in assets to fund the rest of your life, is not possible that you instead build $1.51 million in assets? Why would you put off necessary medical care to avoid a very slight increase in the assets you will need to build up to become financially independent? Are you much worse off in this situation than someone with zero-deductible medical insurance? Their “FI number” is $1.5 million; yours is $1.51 million.
You might argue “but might my insurance company deny my claim?” That is a valid concern with insurance. But it is a concern whether you have a gold-plated, zero-deductible insurance plan, an HDHP, or any other type of medical insurance. Thus, the possibility that you might have to fight with your insurance company to get an expense covered is not a reason to avoid HDHPs.
Risk/Reward Trade-off
When you use an HDHP, you assume additional risk. Put simply, you risk paying annual medical expenses up to the higher deductible. Two things should be noted about that risk. First, it is capped, as described above. A capped risk is the sort of risk that those building up assets should usually be willing to take on, as long as there is sufficient benefit to doing so.
Second, you are compensated for taking that risk. While your future annual medical expenses are uncertain, the benefits of using an HDHP are largely certain and immediate. Namely, they are:
Lower insurance premiums
Income and payroll tax savings (if the HSA is properly funded)
Employer contributions to the HSA on your behalf
Tax-deferred or (if withdrawn correctly) tax-free growth of the investments in the HSA
For taking on the risk of medical expenses up to the annual out-of-pocket maximum, there are two or three measurable, guaranteed benefits every pay period for using the HSA/HDHP combination. And while the fourth benefit can vary greatly (depending on the length of tax-free growth, future tax rates, etc.), it too is a significant benefit.
When evaluating an insurance plan, the risk/reward trade-offs and the costs are what should be evaluated. When comparing an HDHP with a lower deductible insurance plan, you must weigh the assumption of a speculative, capped risk in exchange for the benefits listed above. Based on the protection against very high annual medical expenses and the four benefits listed above, an HDHP appears to be, in many cases, a good risk/reward trade-off for those without expensive, chronic medical conditions.
Conclusion
The studies have not found that an HDHP is suboptimal from a risk trade-off perspective. Rather, they have found suboptimal consumer behavior. That’s where FI comes back in. FI is all about turning around suboptimal saving, investing, and consumer behavior and re-ordering financial priorities. Why shouldn’t obtaining necessary medical care be among the highest financial priorities? Why can’t you examine your own healthcare purchasing behavior and improve it?
There can be good reasons not to select an HDHP based upon your particular circumstances. Perhaps you have a chronic condition, you do not like the HDHP’s particular insurance carrier, and/or you do not believe the risk trade-off benefits are sufficient. But don’t eschew an HDHP because of a limiting belief about something under your own control: your behavior as a patient and medical consumer.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
