Retirement Target And The Rule Of 3 – 2 – 1

Retirement is just not another goal. This goal is different from all other financial goals because here the target amount is never meant to be spent at one go, instead the amount should last really long. Second, here just finding out the inflation adjusted future value of any present value amount will not do the cut. Instead, targeted retirement fund is actually the present value of all future cashflows at the age of retirement. Sounds complicated? Things will be much easier to understand with examples. Read on.

Ingredients i.e., required assumptions and inputs:

Remember the rule of 3 – 2 – 1

Ok, let me explain. To calculate the required retirement corpus, you must consider 3 different ages – your current age (e.g., 40 years), your retirement age (e.g., 60 years) and your life expectancy age (e.g., 85 years).

Next, you need to assume 2 rates – inflation (e.g., 7%), expected annual return from the retirement portfolio after you retire (e.g., 9%).

Last, you need to consider 1 expense i.e., your current household and lifestyle expenses (e.g., Rs. 50,000 per month).

Process i.e., formulae and steps:

First, you need to calculate the future value or inflation adjusted value of current monthly expense. In our case, the current monthly expense is Rs. 50,000 per month (In Excel’s term this is our PV). Here we are talking about a value after 20 years i.e., (retirement age – current age) or in Excel’s term this is our NPER. The rate of inflation assumed here is 7% (in Excel’s terms i.e., our RATE).

Now let us calculate the future value of current monthly expense using the FV formula of Excel:

= FV(7%, 20, , -50000,)

The resultant value is Rs. 1,93,484 i.e., the expected monthly expense on the first month of the first year of retirement. The annual equivalent of the same is 23,21,811 (i.e., 12 X 1,93,484).

 Now is the time to understand the concept of real rate of return or inflation adjusted return. Why? This is because, after retirement inflation will eat away your return from investment. The real return can be calculated using plan arithmetic as below:

= ( ( 1 + expected return from portfolio ) / ( 1 + assumed inflation ) ) – 1

= ( ( 1 + 9% )  / ( 1 + 7% ) ) – 1

The resultant value is 1.87% i.e., the real rate of return or inflation adjusted return that we expect from retirement portfolio.

Now,  we need to calculate the present value (i.e., at the age of retirement) of future cash-flow (between the age of retirement and life expectancy age) using Excel’s PV formula. Excel’s PV formula looks like this: = PV ( RATE, NPER, PMT, FV, TYPE )

For our calculation, RATE is 1.87%; NPER is 25 (i.e., 85 – 60); PMT (i.e., cash-flow amount) is 23,21,811 and TYPE is 1 (as we require the cash-flow at the start of the year). Here is the final calculation using Excel’s PV function:

= -PV( ( 1.87%, 25, 2321811, , 1)

The resultant value is 4,68,94,272 i.e., at around 4.69 Crore – that is the retirement fund you should target to accumulate within next 20 years from now.

NOTES:

1. While considering the current monthly expense, do not consider any current expense that is most probably will not be there after retirement e.g., loan EMIs or expenses towards children.
2. Here, for ease of understanding, I used absolute value inside Excel’s formula. But you don’t do that. Refer Excel’s cell address instead as rounding off decimal values will cause difference in result.