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A recap. Ernie, who earns $100,000, has established a future retirement savings target of $948,750, of which $321,890 is expected to be taken care of by his prior savings. That leaves him $626,860 to save out of his salary. Ernie wants to be equally fair to Present Ernie and all Future Ernies, so he plans to spread that burden over his 25 remaining future years of work.
He could just divide the $626,860 by his 25 remaining years, but that would be, in effect, assuming that his savings do none of the work for him. That’s not realistic. As bad as we all feel about last year’s (and yesterday's) financial markets, it’s not reasonable to assume that will continue indefinitely. I hope. Instead, Ernie recalls yesterday’s reasonable assumption that over the long run, his assets will earn about 6% per year. That’s not a prediction; it’s just a projection.
Ernie projects he will need to save $11,426 per year for the next 25 years, which is 11.4% of his salary. How did he do that? Here are a couple of ways.
• You can use a financial calculator.
• You can use the following formula, where “F” is the future value of the amount you need to save ($626,860); “r” is the assumed rate of return (6%); “N” is the number of years of saving (25); and “Pmt” is the amount of annual saving you’re trying to determine.
Pmt = F * [r/([1 + r]^N – 1)
• You can use an Excel spreadsheet.Are you doing all your retirement savings on your own, or is your employer contributing something? If your employer historically has made a contribution to your retirement plan, it might be reasonable (there’s that word again!) to project that it will continue to do so. That requires another step. But that’s too much for one day. To be continued.
I think an annual annuity in arrears calculation is a little too simplified, since nobody is going to sock away a chunk of change at the the every year. Rather, they'll put it away from payroll deduct over time. That way the 6% works compounding all along. Assuming the 6% is an efffective annual yield so as not to overstate the interest effect, I get a semi-monthly payment (in arrears) of 462.89 which times 24 is only 11,109 per year or 11.1% of pay. Not a huge difference, but anextra 26 bucks in his pocket monthly anyway.
ReplyDeleteAn Actuary
In the real world, Ernie needs to include federal/state/local taxes in his calculations, and assuming that his savings grow tax free until they are distributed, he will need to accumulate between $1,265,000 and $1,450,000 so that he nets the $948,750 after paying all of those taxes.
ReplyDeletea uniform dollar amount over the 25 years employed is ridiculous. The calculation should be in the form of an increasing annuity, not a level annuity. Aside from actuaries, that calculation isn't up to the lay person except through web calculators. The thing to enforce to Ernie is to contribute his 11.4% and not the dollar amount calculated.
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