collage of money, charts, student working and graduating

I Can Do This

I was reading an exam of a student and notice at the top of their paper they had written “I can do this”.  It reminded me that there are some who do not think they can.  Perhaps they’ve tried to save, made a poor investment, and decided that they are just unlucky or not smart enough to invest for their future.  I’ve heard people say this and, when you drill down as to what they are doing, one often finds that they do not have a plan.  If you are a regular reader, you know that a plan for your financial life must follow from a clear understanding of your goals. For, like Yogi Berra said, “If you don’t know where you are going, you might wind up some place else.”  So we will start this year’s financial tip series by encouraging you to set some goals for yourself and, if you have others in your life, their participation is encouraged.

What are some goals you can have for this year?  Let’s take one, retirement, and “run the numbers” to help motivate you to save for this long-term goal. Future editions of this weekly, at least from me, may include additional goals such as college education savings, tax planning, automobile replacement, vacations, and paying off one’s debts.

Save for Retirement.  How much? Median income in Missouri in 2014 was around $48,000.  Let’s assume you are a college student, 22 years young and you plan to retire at the age of 67.  Your goal is to save enough money for retirement income, other than Social Security, to have the purchasing power of the median Missouri income throughout your retirement.  We will assume you can earn 7% on your long-term investments (401k, 304b, IRA, Roth, etc.), will live to be 95, and inflation will average 3% over your life.

Question/Answer 1: How many dollars will it take in 2060 to purchase what $48,000 would have purchased in 2014?  Using a Financial Calculator:

Present value (PV) = -48,000 (goal in today’s dollars)
Number of years (N) = 45 years (number of years)
Interest Rate per Year (I/Y) = 3% (rate of inflation)
Calculate Future Value (FV) =? =$181,517 (goal in 2060 dollars, YIKES!!)

So, we need $181,517 to purchase the same basket of goods we can buy today with $48,000.

Question/Answer 2: If we need $181,517 in the first year of retirement, how much in savings do I need to provide this for the 28 years of retirement.  (The answer to this question will be your savings goal.) We will assume we can invest our money at 7%/year and that we want the income at the first of each year.  (Formally, this is known as an annuity due payment.)

Payment (PMT BGN) = $181,517 per year
Number of years (N) = 28
Interest rate per year (I/Y) = (1.07)/(1.03) = 1.0388350 – 1 = 3.8835% (This is the “real rate of interest” net of inflation.  By using it, we create a payment stream that is able to increase with inflation.)
Present Value (PV) = ? = $3,065,674 (WOW!! That is a lot of money for our retirement goal!!)

Thus, we need to begin to save, in order to have $3,065,674 in our retirement account when we retire.

Question/Answer 3: We will plan to save a constant payment at the beginning of each month (i.e., monthly annuity due payment) for the next 45 years, or 540 months.  How much is that payment?

Future Value (FV) = $3,065,674, our retirement savings goal.
Number of months (N) = 540
Interest rate per year (I/Y) = 7%
Number of Payments per year (P/Y) = 12
Annuity Due Payment (BGN PMT) = ? = $803.64 every month for 540 months[i].

This sounds like a lot of money to save each month, just to have the median spending power of a household in 2014.  Before you get too downhearted, what is the answer if you make the decision to wait to begin saving until you are 32 years old?

Under these assumptions the problem changes to:

Future Value (FV) = $3,065,674, our retirement savings goal does not change.
Number of months (N) = 420 (the only change in the problem, except for the answer)
Interest rate per year (I/Y) = 7%
Number of Payments per year (P/Y) = 12
Annuity Due Payment (BGN PMT) = ? = $1,692.28 every month for 420 months (Or, more than twice the payment that was required had we started saving 10 years earlier!!)

I hope you are beginning to see why goals are important.  The sooner you begin to clarify your goals, you can begin to implement your financial success plan.  After all, financial success is what our Office for Financial Success is all about.

– Rob Weagley

[i] This problem could be done where we calculate a serial payment that grows at the rate of inflation.  While we aren’t going to show our work on this, under these assumptions, the first payment would be $553.52, the second $554.91, the third $556.29 and so on until the 540th payment is made for $2,131.58.