If you were planning a vacation you would start with a desired destination, select the dates you can go, determine your budget, and then tweak your plans to fit your budget. It is the same with financial planning. You have to determine where you want to go (how much income or how big a nest egg you need), set a target date for getting there, determine how much you need to save and invest, and then tweak your plan for the realities of your situation.
If you are planning for a down payment on a home you will have to amass a lump sum that you will be spending all at once. So calculating your need is pretty straight forward. If you want to buy a $300,000 house, you will need to save at least a 10% down payment, or $30,000.
If you are planning to send a child to college you can look up the cost of tuition, books, and living expenses at the schools web site. But unless your child is starting school this year you will have to estimate what future expenses might be, or you will surely come up short due to likely increases in costs between now and the time your student enrolls.
So how do you plan for such price increases? Well, if you do a little snooping around you will learn that college costs have been increasing at about twice the level of general inflation. Armed with that and the
number of years until your student enters college, you can make an educated estimate of how much you will need in the future to pay for this expense, by using one of the 'secret' formulas of financial planning.
It is called the Future Value formula. It is, like the name implies, a formula to calculate the compound interest future value of something. Here's the 'secret' formula:
FV = PV * ( 1 + i )N
PV = present value
FV = future value (maturity value)
i = interest rate in percent per period
N = number of periods
When estimating the future cost of something the i represents the rate you expect that something to go up in real terms. To learn about real rates of return see this previous post.
So lets work through an example. I have a daughter who will enter college in 12 years. The cost of attending a university in my state is currently about $17,000 per year, so in todays dollars I would need $68,000 to pay for her education.
PV = $68,000
FV = future value = ?
i = interest rate in percent per period = 6% (nominal college inflation)-3%(expected general inflation rate) =3%
N = number of periods = 12 years
FV = $68,000 * ( 1 + .03)12
If you are like me you don't have one of those fancy TI calculators you kids use, but that is okay. to solve the ( 1 + .03)12 part you just add 1 and .03 then enter 1.03 times 1.03 into your basic calculator and hit the enter button twelve times. That gives you 1.4685. Now multiply $68,000 by the 1.4685, and presto, you find you will need about $99,860 (lets call it an even $100,000) in inflation adjusted dollars to send little Debbie off to college when the time comes.
Finally, when you are planning for retirement the 'how much will I need?' question is usually answered with a per year income figure. Here you have to estimate what you would need if you retired today. You don't need to adjust this amount for inflation because we will be adjusting investment returns for inflation as we go. So just figure what you would need today (you should make adjustments for children that are grown and gone, and any debts like your mortgage that you expect to be paid off.)
From this income need you should subtract any pension, social security, or annuity income you will receive during retirement. This leaves you with the annual income needs you will have to pay for yourself. For example; I need $50,000 in retirement income. I expect to receive $1,400 a month or $16,800 in social security benefits and a company pension of $12,000 per year. That leaves me with a shortfall of $21,200 per year that will have to come from my investments.
If you have read my post on safe withdrawal rates, you'll remember that the estimated real rate of return on your investments is your maximum withdrawal rate. Let's say my expected real rate of return is 5%. To estimate how much I would have to have in savings and investments to fund the $21,200 per year shortfall in retirement income I would simply divide $21,200 by .05. This tells me I need to have $424,000 in investments to fund the balance of my retirement income needs.