Friday, December 11, 2009

Mechanics of Retirement Planning

A question I posed to some of my classmates who wanted to practice DCF or time value of money questions:

John is 20 years old and is making $100k annually. He plans on retiring at 65 and will require 70% of his current annual income every year thereafter. The general life expectancy is 'til 85. And he can earn 8% on any money he invests.

How much does John need to save per year in order to retire at 65 according to plan?

You would break this question into two parts.

Part I: Nest Egg - Understanding the PV of the money he needs in retirement (aka how much he needs to have saved by 65)
Using a financial calculator:
PV = ?

FV = 0 (Doesn't plan on giving any inheritance when he dies)
PMT = 70,000 (70% of 100k)
P/Y = 1 (1 period per year, NOT semi-annual)
I/Y = 8
N = 20 (Retires and lives for 20 years, 85 - 65)
PV = 687,270.32 (How much his nest egg should be at 65)

Part II: How much he needs to invest every year
PMT = ?

FV = PV @ 65 = 687,270.32 (How much his nest egg should be at 65)
P/Y = 1
I/Y = 8
N = 45 (Works for 45 years, 65 - 20)
PV = 0 (Starts with nothing)
PMT = 1,778.16

John needs to save 1,778.16 per year. Now most people will say: "That seems really low"

That's true, but look at the scenario: John is saving for 45 years and spending for 20 years. For all of those 65 years, John is earning 8% on every dollar he's invested (aka he's not using). This returns to our original point when it comes to personal finance: "You can buy stocks. You can buy bonds. You can even buy good advice. But the one thing you can't buy is time."

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