Friday, September 30, 2005

Retirement - Start early

This is a follow up to the presentation I gave at SCU Toastmaster club. Please check out the actual presentation here. Vanguard - one of the biggest investment management company, in its survey found that the happies retirees were the ones that were married, had grand kids and left their last job voluntarily. So, in that list money did not figure high. But in my opinion, we cannot plan for retirement based upon the current retirees. For one, we wont have any pension, social security or any of those perks. In addition to that we are going to live longer than this generation of retirees. So, If we need to enjoy our retirement blissfully with our loved ones, a little bit of monetary planning is not out of line.

This draft was written under the assumption that we are planning to retire in the year 2035 and are planning to live until 2065 and that our investments grow at a YoY rate similar to historic S&P 500 standards (8%) until 2035 and that after retirement, we will invest in more conservative venues (4%). Even though mileage varies from person to person as to how much one needs for retirement, for simplicity we have kept one universal standard. I also give the calculations below, so that you can increase or decrease as per your requirement.

Objective: To generate a cash flow of $10,000 (in today's money) every month for 30 years (from 2035-2065). If we take 2% as the inflation, $10,000 today's money is $10,000*(1.02)^30 = $18,114 in the year 2035. So, our objective is to generate a cash flow of $18, 114 (in 2035's levels) every month from 2035-2065.

How much lumpsum we should have in our nest egg in the year 2035 to generate the cashflow mentioned in the last paragraph? FNCE 101 says,
PVA ($18,114, 4/12%, 360) = $18,114*[1 - (1 + 0.04/12)^(-360)] / (0.04/12)
This comes to $3, 622, 003. (Already mentioned that in retirement, we will have an investment that returns 4/12% every month (not the same as 4% every year) and we need that cashflow for 30 years which is 360 months.

Next question is how much one needs to invest to get $3,662,003 in the year 2035. If you start now (with no savings until now), you have 30 years with you. We can also assume that our money grows at 8% YoY in that period. So, to find out how much monthly investment we need to make @ 8% return for 30 years to get $3,662,003 in 2035, FNCE 101 again says

FVA (A, 8/12%, 360) = $3, 662, 003.

In other words,

A [ (1 + .08/12)^360 - 1 ] / (0.08/12) = $3, 662, 003
Solving for A, we get A = $2428 per month. So, we need to invest $2428 per month @ 8% rate for 30 years to reach our goal. This seems like an uphill task. Agreed, that we took the most conservative approach (i.e., no social security etc.,). Also, we have not accounted for the tax benefits in 401(K). So this investment of $2428 per month pretax comes to around $2000 effective money per month.

But the point I am trying to make is if you delay your start, the task is going to be phenomenally uphill. For instance if you start only in

2010, then the pretax monthly investment that is required to meet the objective is $3806 (Solve the same equation with 300 instead of 360).

2015, then the pretax monthly investment that is required to meet the objective is $6146

2025 then the pretax monthly investment that is required to meet the objective is $19793.

and you are losing on all the tax benefits for so many years. What are you still waiting for ? Follow the pointers in the ppt and learn more about retirement today.

Peace out
Yours truly.


At 8:58 PM, Blogger Gaurav said...

Nice one sai. I think this is what I like to calculate the first thing. How did you get that formula? Can you point me to more details?

At 2:24 PM, Blogger Sai G said...

I will tell more about it when we meet @ Pradnya's party :) But it involves very simple annuity calculation (summation of geometric series).

One thing which i didnt mention explicitly is that I have assumed 4% real interest rate after retirement and 8% nominal interest rate before retirement.


At 4:12 PM, Blogger Gaurav said...

4% real interest rates are i believe achievable by inflation protected bonds. I am not sure how safe they are and whether they are govt. backed. 8% nominal annual rate of return is also achievable by just indexing. Depending on how many risky/smart investments you make personally apart from this, that rate can either go higher or lower. But, if you can make sure to not loose more money than you invest in those stocks/funds, then your 8% return from indexing is guaranteed.


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