Today’s Classic is republished from Physician on Fire. You can see the original here.
Do you know how much you should be spending on luxury? What does it mean to spend on luxury, exactly?
My friends Dror and Jesse have a rule for that and a way to help you define what luxury spending means. Another rule, you ask? Don’t we have enough rules already?
Let’s see. There’s the 1% rule for investing in rental properties. You’ve also got the 10% Rule for limiting lifestyle creep. And, of course, there’s the 4% rule (of thumb) defining what’s likely a safe withdrawal rate in retirement.
But hey, what’s one more percentage-based rule? I think you should hear these two engineers out. If you play your cards right, you could end up with a very large luxury budget to support a fun and very comfortable fatFIRE lifestyle.
Hi PoF Readers! We’re Dror and Jesse. And we’d like to introduce you to the 1% Rule, a heuristic we’ve found useful in our pursuit of FIRE. A quick introduction:
I’m Dror. I’m an engineering professor, and my research looks at various estimation and prediction algorithms. I’ve had an interest in quantitatively driven investment approaches for a while and worked at a hedge fund from 2007 to 2008. I’m not a classical FIRE person, however. I don’t want to put a dollar number on retirement. Instead, I want to work on things that interest me, and growing my resources makes it easier to pursue my interests.
And I’m Jesse. I’m an engineer by day and a financial writer/podcaster by night. I write at the Best Interest and run the Best Interest Podcast. I don’t have a specific FIRE number or date in mind. But I do want the flexibility of early retirement if I so choose. My savings rates will look pretty familiar to many of you overachievers! Here’s my 2020 FIRE/blog / foster-dog breakdown.
Let’s get into the good stuff: the 1% Rule.
Dror’s Learning Process
Dror: After I completed my Ph.D., I started thinking about my future and realized that with a long time horizon ahead of me, every dollar that I could save would greatly increase its purchasing value later. While splurging on various things can be fun, I realized that buying myself financial security and independence was far more valuable.
Simultaneously, some sense of balance is helpful, and it was nonsensical to skimp on necessities. I wanted to identify – in a quantitative way – a reasonable trade-off between being comfortable while not being wasteful. To do so, I separated between needs and wants/luxuries. I wanted to fully fund the necessities of life but limit the resources spent on luxuries.
For example, I recall thinking about my expenses around 2005. I knew that I was spending $2-3k per year on miscellaneous fun stuff, and that was fine because I was saving and investing much more. There was certainly no need to budget. On the other hand, I could see myself spending somewhat more a few years later. A few years went by, and as my assets increased, my luxury spending crept up. I was well aware of the 4% retirement rule and realized that luxury spending could increase, but it’s wise to keep it proportional to wealth.
Thus, the 1% Rule was born!
Enacting the 1% Rule
The 1% Rule asks you to keep two sets of books—a schism in your budget.
The first post covers all of the necessities of life. It has no upper limit in size. It grows to meet your needs. But spending on non-necessities from this pot is not allowed.
The second pot covers all the luxuries in life. When you are just starting with modest wealth, spending several thousand a year (as Dror did in grad school in 2005 and Jesse did in grad school in 2014) is fine. But you must limit your second pot until your wealth level allows you to do so. Once your wealth is sufficiently high, the pot is capped at 1% of your net worth per year.
But within that 1%, you have absolute flexibility on how you spend the money.
In general, the 1% Rule is targeted at somewhat wealthy individuals. A younger person or new FIRE pursuant might only have a 4- or 5-digit net worth. Should we expect that person only to have a 2- or 3-digit luxury budget to cover an entire year?
Jesse: For example, I had a net worth of (-$50,000) at age 22 (I’m now 30). Grad school then delayed my debt pay off, so I didn’t achieve a positive net worth until age 26. The 1% Rule would dictate that I was allowed zero luxury for those four years. Is that reasonable?
I’m all for minimalism, spartanism, and simple living. I save a lot of money in my life by eschewing otherwise-common expenditures.
But there’s a world of difference between no luxury budget and a little luxury budget. Let me have a burger and fries. Let me go camping. Give me a pint of Genesee beer. I don’t need much, but I do need something.
But for the 6- and the 7-figure net worth crowd, the 1% Rule makes a lot more sense. Someone with a $500K net worth is allowed $5000 for a full year of luxury spending or $400+ per month. You can pursue many luxurious passions on this kind of budget.
We know this might feel extreme to some readers. And that’s ok. We want to present something effective for us.
There is the elephant in the room: what is luxury?
How to Define “Luxury”
Enacting the 1% Rule in your life comes down to how you define ‘luxury.’
It’s a subjective question. Is a steak dinner a luxury? What about a necklace for your spouse? Heck—what about a car? Mr. Money Mustache would probably call a car luxurious!
Dror: In many countries and parts of the US, public transport is fine, and you don’t need to have a car. For those people, any car ownership might be a luxury.
But most Americans live in locations with mediocre public transport, and a car becomes a need.
If you mostly drive short local commutes, then a used car might suffice, and that could be your need. And a new car could be a luxury.
Personally, I love going on hiking trips, and having a reliable vehicle is important to me. That said, I kept my previous car for almost 10 years. The extra costs relative to buying used are probably under $1k a year (note: Jesse wrote a breakdown on car ownership cost here). We can interpret the extra cost as ‘luxury.’ But should we budget it under transportation or travel? It doesn’t matter, as long as luxuries are kept under 1%!
Jesse: How do I define ‘luxury’? I think about Vicki Robin‘s famous Fulfillment Curve. It suggests that spending does increase your life’s fulfillment, but only up to an upper limit. Eventually, more spending adds more stress.
During the “increasing fulfillment” phase, Robin suggests you consider spending for survival, comfort, and luxury.
I think about my spending in these three camps. For example, let me consider coffee, the single-most cliché expense in all of personal finance.
Survival: No coffee. It’s not needed for me to survive.
Comfort: My current solution. A simple $40 at-home coffee machine and mid-grade bulk ground coffee.
Dror interrupts: It’s all a question of what fits into your individual style. On the one hand, if instant coffee is good enough for my parents, it’s good enough for me! On the other hand, pre-pandemic, I worked a great deal at Starbucks. I’m more creative and work more efficiently there, and spending a few dollars on coffee is an investment in doing good professional work.
Jesse again: Luxury might be a top-of-the-line brewer, top-quality beans, specialized tools, etc.
I enjoy coffee. I view it as a comfort and spend accordingly. It’s not a 1% luxury for me.
But if I loved coffee, I would spend some 1% money on a luxurious coffee experience. The spending difference between a “comfort” setup and a “luxury” set-up would get docked from my 1% budget.
Example of the 1% Rule
Let’s imagine Thor, a Blacksmith-on-FIRE. Thor has hammered himself half-way to his FIRE target number. He’s at $1.5 million of his $3 million goals.
This 1% Rule enables Thor to take $15,000 this year and spend it on complete luxury. Anything he wants.
- A new flamethrower from Elon Musk? Sure.
- A decorative golden anvil to set above his fireplace? That’s ok.
- A replica hammer from the Avengers, signed by Chris Hemsworth? As long as it falls within Thor’s $15,000 luxury budget, it’s perfectly fine.
Depending on your tastes, $15,000 can go a long way. That’s $1,250 per month. It could pay for a nice dinner every weekend and still cover three $3,000 trips to Iceland, Sweden, and Asgard.
Since Thor is confident that his investment portfolio (mainly low-cost index funds) will go up over time, he knows that his luxury spending will slowly increase. He gets a reward for his diligence.
You can call it lifestyle inflation, but it has an important upper limit—no more than 1% of his net worth per year.
The Math of the 1% Rule
The 1% Rule acts as a terrific heuristic. If you follow the rule, then the underlying math works in your favor. There are plenty of things to like about this approach.
Dror: Over time, my portfolio is growing, and I’m increasing my lifestyle, which is fun. The 1% approach is different from the lean FIRE crowd, who might avoid all luxurious spending.
And over time, my luxury spending will approach my spending on needs. At some point, it’ll become a no-brainer to retire. But for now, I’m trending toward being able to retire with a withdrawal rate well below the 4% retirement rule.
One of the problems with 4% is that you can’t realistically expect to keep increasing your lifestyle. Another problem is that you’re prone to mishaps (a traffic ticket or medical problem) where you accidentally overspend.
For example, during the pandemic, I had a minor medical problem. I ended up spending $1,000-1,500 on co-pays, and the insurance company obviously spent more. These things happen. I can’t imagine living without liquidity.
The 1% Rule fixes those problems. It creates a gradual transition toward a lifestyle that’s funded mainly by my portfolio income instead of my career, and I’m more protected from mishaps.
Can You Tell We’re Engineers?
The 1% Rule acts as a “safe equilibrium” of sorts. It helps ensure financial safety without being too stingy.
A similar equilibrium might be reached riding your bike down a hill. If you don’t touch the brakes, you’ll fly! But a small wobble could get amplified into a complete disaster. If you squeeze the brakes too hard, then you’ll waste time and have less fun. But if you touch the brakes to maintain control, you’ll optimize the combination of speed and safety.
The 1% Rule acts as that slight brake, optimizing your combination of spending and saving.
We both think of the 1% Rule of falling into different phases. Let’s use a hypothetical doctor—we’ll call him Leif—as an example to walk us through phase by phase.
Phase 1–Pre 1%: Leif finishes med school, finishes residency, finishes any other post-school obligation (that these engineer authors didn’t have to worry about).
The debt. Oh sh**, the debt. “What’s 1% of (-$300,000)?!?!”
Don’t worry! The engineer/authors went through similar low net worth phases in their grad school. We recommend a “modest” luxury budget in this Phase. For Dror and Jesse, “modest” luxury meant $2-$3K a year. If you’re a FatFire physician, maybe $10-$15K makes more sense.
Phase 2A–1% Starts Making Sense: Leif now has modest wealth. His needs are met by about 5-20% of his total wealth per year.
E.g., Leif’s net worth is $500K. He spends $5000 per month, or $60K per year, on needs. Therefore, he spends 12% of his wealth on needs per year. (If he lives in an expensive city and $5K per month is unrealistic, it might take Leif longer before this phase works for him.)
In this phase, the 1% Rule starts to make sense. 1% of $500K is $5000. That goes pretty far if it’s covering just luxury spending.
Phase 2B: A few more years have passed, and Leif’s needs are now only 2-3% of his wealth. For simplicity, we’ll say Leif’s needs are still $60K per year. That puts his net worth in this part at $1.5M or higher.
The 1% Rule suggests that Leif could freely spend up to $15,000 (1% of $1.5M) per year on luxury, or $1250 per month. Just like our friend Thor. Not bad!
Phase 3: Leif’s needs are now ~1% of his wealth ($60K per year → ~$6M net worth). His luxury spending is another 1%, via the 1% Rule. It’s a lavish life! $60K per year on luxury alone!
And yet, Leif is only spending 2% of his net worth per year. That’s way under the 4% Rule’s famous suggestion as a safe withdrawal rate. He’s in the clear! Leif is certainly financially independent.
Some of you might think, “$60K per year on luxury?! That’s way more than my family would ever spend. We spend $40K on needs and $10K on luxuries…and that’s it!”
That’s excellent! Each of us needs to find a smart balance between needs spending and luxury spending that makes sense. We also each have our own risk tolerance regarding an “X% Rule” of safe retirement. Many of us are familiar with Big ERN’s work on this topic.
For the example above, the $40K needs and $10K luxuries is a clean 4:1 ratio. We could easily fit this into a “4% Rule” by saying $40K = 3.2% and $10K = 0.8%. This yields an FI target of $1.25M. We can go more conservative, targeting a 3% Rule where $40K = 2.4% and $10K = 0.6%. This yields an FI number of $1.67M.
1% to Go
In conclusion, the 1% Rule is a useful and conservative heuristic to balance luxury spending on your path to financial independence.
It allows your fun money to grow as your net worth grows but places a ‘brake’ on your budget to prevent you from overspending. And when the time comes to consider retirement, the 1% Rule fits nicely into the traditional “4% Rule” framework. The math is already done for you.
Thanks for reading, folks. We’d love to hear what you think by leaving a comment below or reaching out to us directly.
Dror can be reached at firstname.lastname@example.org and is active on Twitter @BaronDror.
Jesse writes at the Best Interest and is active on Twitter @BestInterest_JC.