Is the Financial Independence (FI) Ratio More Useful Than Net Worth?

I’ve been working toward “work-optional” status (not to say retirement) for a long time.

Long enough that, once achieved, it won’t be considered “early retirement.”

An important part of this journey has been tracking our income and expenses, as well as our progress toward financial independence – the point at which we have enough to no longer need to work for money and can instead work on things that interest us at the level we want regardless of pay, travel, etc.

One of the important numbers I look at is our net worth.

Net Worth – What It Is and Why It’s Important

Net worth is the total value of all our assets (e.g., investments, bank accounts, rental properties, homes, cars, etc.) minus the total we owe (mortgage, business loans, auto loans, credit card balances, etc.).

Unless you’ve been living under the proverbial rock (or just haven’t read much about personal finance), you know how important your net worth is.

It’s one of the main measures of wealth.

• If you have between $1 million and $5 million, you’re considered a “high-net-worth individual” (HNWI).
• Reach between $5 million and $30 million and you’d be considered a very-high-net-worth individual (VHNWI).
• And if you ever exceed a net worth of $30 million, you’d join the approximately 225,000 wealthiest Americans considered ultra-high-net-worth individuals (UHNWIs) – less than one-tenth of one percent of the population!

If you want to know where you fall in the wealth distribution, DQYDJ.com can show you in what overall net worth percentile you fit, or you can read about your net worth percentile by age on Wealthtender.

What’s in a (Net Worth) Number (and What Isn’t)?

But as important a number as net worth is, it won’t tell you if you can stop working!

Why?

Because it doesn’t take your spending habits into account.

For example, say you’re a HNWI with a $2.5 million portfolio – putting you in the 92^nd percentile of net worth with enough to be considered wealthy (per the 2024 Schwab Modern Wealth Survey). 

That may not be enough for you to quit working if your annual spending is too high.

If your desired retirement budget is $20k a month or $240k a year, you’d likely need a portfolio of more than $5 million (where for simplicity, I assume $40k Social Security benefits, use the 4-percent rule, and include taxes in the above budget).

In that scenario, despite being considered wealthy, you’d only be halfway to your work-optional goal!

On the other hand, if your annual retirement budget is a more modest $100k (using the same assumptions), your portfolio would already be about 67 percent more than you need!

A Better Number to Track – Your Financial Independence (FI) Ratio

Since your retirement budget determines how big a portfolio you’ll need to retire, a better number to track is the ratio of your passive income to your budget, also known as your Financial Independence (FI) ratio.

For example, if you need $10k a month or $120k a year to retire comfortably and your passive income is $60k a year, your FI ratio would be 50 percent ($60k divided by $120k).

In passive income, you’d include things such as:

• Social Security benefits (once you claim them)
• Annuity payments (if any)
• Net rental income (above what’s needed to cover the rental’s expenses)
• Dividend payments
• Interest payments
• You could also include the proceeds from selling assets, but you’d need to have a solid plan for not running out before you die.

Once your FI ratio exceeds 100 percent you can stop working for money. You’ll have reached what I call work-optional status.

In this status, you can choose what you want to work on, with whom, at what level of effort, when, where (or even if at all!) with no regard to how much, if anything, it pays.

While I wouldn’t recommend it, you could even just lay on a couch in front of your TV for the (shorter than it needs to be) remainder of your (uninspiring and unhealthy) life.

The Benefits of Using the FI Ratio

At this point, you may be thinking that you could simply use the 4-percent rule or something like it to determine the net worth you’ll need to retire and then track your progress toward that goal instead of using the FI ratio.

If so, you’d be right, but…

You’d be giving up several advantages of the FI ratio:

• Your net worth fluctuates with the market: If you invest in risk assets such as stocks (or even more so crypto) as you should especially earlier in life, your net worth will go up and down, and some years could drop by half or more! This is very disheartening and could throw you off your financial game. Passive income (excluding the sale of assets), on the other hand, is far less volatile, so your progress will be much smoother.
• The FI ratio puts equal weight on controlling your spending: The quickest way to reach FI is to minimize lifestyle inflation – the tendency to spend more when you earn more – and thus reduce your eventual retirement budget. For example, say you decide to trim your annual retirement budget from $120k to $100k. Without changing your passive income one iota, you bump up your FI ratio by 20 percent! If your passive income was previously $100k, leading to an FI ratio of 83 percent, your new FI ratio is 100 percent (1.2x 83 percent) and you can quit your job!
• As a result, the FI ratio gives you insight into what it takes to retire: Is having a $120k-a-year retirement worth staying at your high-stress job, working for an unpleasant boss for the many years you’d need to build up your net worth high enough? Or would you rather quit now even if it means living on (say) $90k a year?
• It shows the impact of part-time income: While it isn’t passive, if there’s something you’d like to do that would bring in some money, even if it’s far less than your current income, you could include that in your FI ratio. Say you currently make $150k a year from a job you despise. If your FI ratio is, e.g., 75 percent ($90k a year out of the $120k you might need to retire), shifting to something you’d love to do but that would only bring in $30k a year bumps up your FI ratio to 100 percent! Note however that you’d need to figure out how to replace that extra $30k (or reduce your budget by $30k) once you no longer want to do any work.

Ultimately, while net worth shouldn’t be ignored, in most cases it isn’t as critical as many think.

Jon McCardle, President & CEO of Summit Retirement Advisors explains, “While net worth is a common metric, its relevance is limited to specific scenarios, like borrowing, or an entrepreneur planning a liquidity event. One notable exception is real estate beyond the primary residence, where equity becomes a key component of sustainable income and debt management strategies. 

“When discussing finances with clients, the conversation often centers on the value of their accounts. However, translating that value into practical terms – such as monthly gross income using a 3 percent or 4 percent withdrawal rate – offers a more actionable perspective. 

“For those aiming to achieve or maintain financial independence, prioritizing the liquid portion of their net worth is crucial. This allows for a clear plan to develop income strategies and align them with personal goals. 

“Ultimately, the most significant components of a client’s net worth are liquidity and entitlements. These are what will sustain them throughout retirement, ensuring stability and security. Shifting the focus from net worth to income planning and liquidity fosters a more meaningful and goal-oriented approach to retirement readiness. As advisors, our responsibility, in my opinion, is to guide clients toward the financial metrics that truly matter. 

“A valuable insight from a mentor of mine resonates deeply: ‘A client cannot feed their family with their net worth.’ This wisdom underscores the importance of focusing on metrics that directly impact a client’s financial independence, especially in retirement. Instead of dwelling on an abstract number, we emphasize actionable metrics that guide real-life decisions.”

The Bottom Line

Your FI ratio is much more telling than your net worth, but it’s still useful to keep tracking the latter too, especially if you plan on gradually selling assets during your retirement to cover part of your expenses. As Nick O’Kelly, Lead Advisor at Cadence Wealth Partners says, “While net worth is a key figure, the true measure of financial freedom is your projected monthly cash flow. It’s crucial to consider expenses, too. Relying solely on net worth can be misleading, as it doesn’t always predict future cash flows. For instance, people with pensions might have a lower net worth but can maintain a cash flow similar to someone with a much higher net worth.”

Still, the higher your net worth, the less aggressively you’d need to invest your money, reducing the risk that your portfolio might crater just as you’re about to retire (or worse yet, right after you tell your boss what he can do with that job!).

Your best bet is thus to track your net worth, your FI ratio, and (borrowing from Ramit Sethi) what fraction of your net income you spend on non-discretionary expenses (think mortgage, utility bills, insurance, auto payments, etc.). 

Sethi recommends keeping this number between 50 and 60 percent, spending another 10 to 25 percent on what he calls “guilt-free spending,” and splitting the remainder between short-term savings (5 to 10 percent) and long-term investing (15 to 20 percent).

Keeping your fixed expenses low lets you trim expenses when, not if, your portfolio is hit by a bad year. This helps you avoid a retirement “death spiral” where you’re forced to sell ever more shares due to their lower value, quickly depleting your nest egg and forcing you into poverty.

Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.