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How you can retire early and be financially independent on an average salary

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According to the Annual Survey of Hours and Earnings from the Office for National Statistics, the figure for medium gross annual earnings for full-time employees in the UK stood at £28,600 during April 2017.

If you are earning a salary somewhere close to that amount is there a realistic chance that you could save enough to retire early and become financially independent? The short answer is an emphatic ‘yes’ and here’s how you could go about achieving it:

Step 1, reality check

You’ve got to save some money and you’ve got to save some every month. There, I’ve said it! There will be an element of sacrifice along the way because you’ll need to live below your means and not spend every penny that you earn.

However, I reckon you can live a balanced lifestyle – spending enough to enjoy life without being extravagant – and still commit to regular saving to fuel your retirement plan. Step one in your plan to achieve financial independence and to retire early should be to save as much as you can, as regularly as you can.

Step 2, the turbocharger

With regular saving, it won’t take long to build up a pot of money in the bank and when you do that you are in a strong position. The key to getting rich on your savings is to make the money you’ve saved work as hard as you are working, by taking advantage of the process of compounding. You need to make sure that the money you’ve saved earns interest, the interest earns interest and the interest on the interest earns interest… and so on.

Albert Einstein once described compound interest as the eighth wonder of the world. He reckoned that those who understand it, earn it, and those that don’t understand it, pay it! And you certainly need to understand compounding because it will turbocharge your efforts to achieve financial independence and early retirement.

Do you think you could save £500 per month, for example, if you really tried? If so, you’ll be putting away £6,000 every year. After 10 years you’d have a pot worth £60,000. Not bad, but now consider what would happen if you raised your monthly saving amount by 3% every year as your wages grow in order to keep up with inflation. After 10 years you’ll have saved £68,783, which is better. But the kicker is to add compound interest to the money you are saving. If you earned just 5% interest on your savings every year, the process of compounding would turbocharge your savings after a decade to £89,768.

Step 3, the accelerator

If you carried on raising the amount you save by 3% each year and compounding 5% interest, you’d save £266,854 after 20 years. If you increase the amount you initially save each month, or increase your monthly savings by a greater percentage each year, or earn a higher rate of interest for compounding, or all three, the final amount in your savings pot will likely be much larger after 20 years because little increases in the percentage figures make big differences to the end figure.

Why not think of the interest rate that you earn on your money as the accelerator? And it really is a responsive instrument — you don’t have to push the interest rate accelerator very hard to speed up the rate that your retirement savings pot accumulates. Little increases in the rate of interest will make a big difference to the size of your eventual pot over 20 years or so.

However, today’s low bank interest rates are less attractive than shares on the stock market, which often pay dividends at a higher rate than bank accounts pay interest. Add to that capital appreciation from rising share prices and it’s clear that shares can be a good vehicle for compounding. Indeed, with their long-term record of outperformance over other asset classes, shares, in general, can be the best form of investment and a decent vehicle for compounding your savings.

Step 4, the strategy

One example of what can be achieved with regular saving, investment, and the power of compounding exists in the story of Anne Scheiber. She was a reclusive and frugal New Yorker who worked as an auditor for the Internal Revenue Service in the United States. She retired in 1944 having never earned a salary higher than $4,000 per year. Yet by the time she passed away in 1995 at the age of 101 she had accumulated around $22m.

She retired in the 1940s and managed to invest and compound her money throughout her retirement to achieve that fortune.  However, her investment record was steady but unspectacular in terms of annual gains. Her executor, Benjamin Clark, reckons she had around $21,000 in investments in 1936, so compounding $21,000 for almost 60 years to end up with $22m indicates a return slightly higher than that from America’s S&P500 index.

Anne Schreiber bought high-quality companies for long-term growth and dividend income and sold few of her investments during her lifetime. However, these days you could probably achieve a similar outcome by investing your money in simple, low-cost index-tracking funds such as those that emulate the performance of the FTSE 100 index.

Step 5, start now

It isn’t necessary to live a frugal and reclusive life in order to accumulate a fortune like Ms Scheiber did, but it’s important to start your retirement saving as soon as you can. The money you save in the earliest years of your earning life has the longest amount of time to compound. After all, the ‘magic’ ingredient of compounding is time.

So, the keys to success are to treat small increases in annual interest as a big deal. That’s because little increases make a big difference to the final pot. Save consistently and do it for as long as you can.

Good luck on your journey to becoming financially independent and retiring early. I’m sure you can do it if you put your mind to it.

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Views expressed in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.