The answer to this question usually falls into two categories
a) The helpless shrug : This is the most common non-verbal form of “I have absolutely no idea of how to answer that”. While it’s true that it can be hard to estimate this value, but it isn’t impossible. The reason why most of us tend to stick to the helpless shrug, is because our education system fails to provide us with this valuable information.
b) The magical number : While many stay honest and agree to not knowing the answer, there are some who are confident and seem to be aware with what their needs will be down the road. However, when they reveal the magical number $X, the calculation that led to it fails to account for several factors.
By the fifth or sixth grade, a child in most education systems learns the basics of arithmetic and is also aware of the principles of simple and compound interest. While schools often emphasize how important these concepts are, they fail to teach us the real value. While kids have memorized the formulas to several equations and learned how to solve these problems on paper, they have no idea what to do with it when they step into the real world. What we end up with is information with ZERO value.
You may find several resources or online calculators that may help you figure out this retirement number, but you owe it to yourself to use your own experience and knowledge to compute it for YOU. Your financial future and the ability to be financially independent is in your hands and you surely cannot totally rely on an online tool, correct? If you agree with me, let’s come straight to the point and begin our process with a simplified example:
Let us consider the example of John, who is a 30 year old man, whose monthly expenses are $ 2500.
John suddenly decides that he no longer wishes to work paycheck to paycheck and quit his job and write his own book. He understands that book writing can be a difficult and time consuming process and wishes to give himself a span of 10 years. Now he wants to calculate the amount he needs to save today, to be financially independent for the next 10 years.
The most important factor to consider here is inflation. The current US inflation is at 2.9% (https://www.usinflationcalculator.com/inflation/current-inflation-rates/)
[NOTE: This calculation can be valid for any nation and I have considered the example of USA and it’s inflation. You could modify this based on the country you live in for your calculations]
Assuming that John’s lifestyle remains relatively the same through this time, we can calculate the amount he will need 10 years from now for his monthly expenses.
Using the FV(Future Value) function in Excel, I was able to compute the monthly expense adjusted to inflation as $3327.31. For simplicity we will round off to $3500/month.
Now John needs to calculate the amount he needs to have saved in his bank account to make sure he can make this monthly payment of $3500 for the next 10 years. The savings account in US has an approximate interest rate of 1%. We will now use the PV(Present Value) function in Excel to compute the amount he needs in his bank account today.
As you can see from the formula, I have divided the bank interest by 12(B21/12). This is because John will be making a monthly withdrawal from his bank and the interest rate is annual. Also the number of periods is multiplied by 12 as he will need a total of 120 payments over 10 years (12 months/year). The future value used is 0, assuming John will have no money left at the end of this 10 year period. Therefore, John will need approximately $400,000 today if he wishes to quit his job and write his own book.
[NOTE: Again, I have used the bank interest rate for USA and you could easily use the average banks interest for your own country. For example, India has a savings interest rate of 4% and this would change these numbers drastically.]
In contrast to saving all his money today in a bank which pays low interest, if John decides to invest in the market with an Index Fund, these numbers would change significantly. Let us consider he invested in the Vanguard Index Fund (https://money.cnn.com/quote/mutualfund/mutualfund.html?symb=VIIIX). The last 10 years have an average annual return of 10.19%. Let us plug in this value to our calculation and see how the values change:
As you can see the savings needed today has reduced significantly to around $263,000!
While the calculations may appear simplistic, but it can surely give you an idea where you stand today with respect to your goals of achieving financial freedom. The right time to start planning is TODAY and NOW!
Be Frugal, Be Smart, Be Rich!
PS: If you wish to use this simple template for your needs, please contact me and I will email it to you.