Long gone are the days of the feudal period when ensuring financial security included having enough children to provide for you when you could no longer work your farm. The keys to a financially secure retirement are to start early and plan intelligently. To make this discussion simpler we will follow the financial planning of William who is concerned that he has not begun to save for his retirement.
William is a car sales associate making $40,000 a year. He is in good health and there is no reason to believe that he will be able to work until he retires. At 40-years old, William wishes to retire in 25 years when he is 65 years old. However, William does not know where to begin to ensure financial security when he retires. The four steps below outline the calculations, planning, and decisions he needs to make to ensure his financial security.
Step 1: Calculate Discretionary and Disposable Income
The first step William needs to complete in planning for financial security is to calculate discretionary income. Discretionary income is defined as the money you make minus the money needed to sustain life. Essentially, you need to subtract out of your income that money needed to provide you with food, water, shelter, and clothing. Once you have a discretionary figure, subtract out the amounts you need for entertainment, insurance, auto payments, and any other financial obligations you have. Do not forget to subtract out some money you may need in an emergency; consider this your working capital. The figure left over is your disposable income and represents the amount you have available for investment. After William made the calculations above, he discovered that he has $8,000 of disposable income available for investment. Of course, William could just put this amount in the bank and at the end of 25 years have $200,000. However, given that William wants to be sure he has enough money to last until he is 90 years old or 25 years after retirement, he would only have $8,000 a year to live on in his golden years. Investment is his only option to a secure retirement.
Step 2: Calculate How Much Money is Needed at the Time of Retirement
William figures that he needs about $20,000 a year to live after retirement and that he will be receiving $8,000 a year in social security. Therefore, William needs an additional $12,000 a year. Given that William wishes to be conservative and assume he will live to 90 years old, he needs to have $300,000 at the time of retirement.
Step 3: Calculate the Necessary Return on Investment
William has $8,000 a year to invest over the course of 25 years until his retirement. What return on his investment must he receive to turn $8,000 a year into $300,000 in 25 years? The answer can be calculated using the Future Value of an Annuity formula. An annuity is an investment (or payout) that is regularly occurring over time. Lottery payments, insurance premiums, and even one’s paycheck can be considered an annuity. The Future Value of an Annuity formula is given as:
FVA = CF * [((1 + r)n) / r]
where FVA is the future value of the annuity, CF is the cash flow (yearly investment), r is the rate of return, and n is the number of periods (years until retirement). Since William needs $300,000 (FVA) in 25 years (n) with an investment of $8,000 per year (CF), we need to solve for r to find the rate of return that will turn his investment into the anount he needs at retirement. Plugging these numbers into the formula above, we have:
300,000 = 8000 * [((1 + r)25) / r]
Solving for r we get 3.2138 or about 3.21%. To turn $8,000 a year for 25 years into $300,000 William needs to realize a yearly return of 3.21%.
Step 4: Find Investments that Match Your Needed Rate of Return
In William’s situation, he needs only to realize a 3.21% return on investment to achieve his financial goal of $300,000 in 25 years. Although it is beyond the scope of this article to make actual advisements where William should invest his money, we at least now know that he needs only realize a meager return on investment to meet his goals. Give that William is still a fairly young man, he should invest in moderately risky investments that will yield him a return in the 4% to 8% range. Were he younger, riskier investments (those expecting a return of 8% or more) would be advisable since he has time to make up for any loses at an early age. Were he older, investments that are more conservative would be most appropriate.
There is a variety of investment opportunities available to William and diversification or not putting all of one’s eggs in one basket is the key to reducing the risk involved in investing. Conservative investments such as Certificates of Deposit (CDs), some mutual funds, and other investment opportunities should put William on the right track to meeting his goal. In addition, since the investments will be made over the course of 25 years, William can always readjust his investment portfolio to reflect underinvestment and overinvestment problems along the way.
Complications and Conclusions
Several complications are ignored in the example above that make the process of planning for financial security difficult. First, inflation was ignored. Inflation is the consistent devaluing of currency over time. Essentially things in the future will cost more than they do now. For example, even at a conservative 2% inflation rate, $300,000 in 25 years is worth only about $183,000 today. Assuming that William’s yearly investment kept up with inflation, the principles outlined above remain valid.
Second, the steps above assume that William would not be making any more money over the next 25 years than he is making today. Promotions, changing jobs, or other factors could yield more money for investment.
Third, the steps above ignore one major aspect to investing. Any investment made means that your money is at risk. Just because William needs a return of 3.21% doesn’t mean he will consistently realize that return over the course of 25 years. He may need to shoot for a higher return to make up for those times when he loses money in his investments. To take all these and other complications into account, much more complicated calculations than those outlined in the steps above are necessary. However, the steps above do provide a planning framework for financial security in retirement.