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Author: Ripper14 Two stars, 250 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 74759  
Subject: FV calculation help Date: 12/6/2010 1:08 PM
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I'm having trouble trying to calculate the future value of an increasing investment. Here's my inputs:

Current investment account value: $40,000
Current salary: $80,000
Yearly salary increase (est): 2%
Current investment as % of salary: 5%
Current employer match as % of salary: 5%
Estimated investment acct yearly return: 7%

What will be the value of the account be in 30 years?

The part I'm having trouble with is the fact that the amount invested increases each year because the salary goes up. I can do the math on a constant investment, but can't figure out the math for an increasing investment. Any help out there?

Thanks,
ripper
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Author: pauleckler Big funky green star, 20000 posts Top Favorite Fools Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 67798 of 74759
Subject: Re: FV calculation help Date: 12/6/2010 1:59 PM
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It is fairly easy to create a model for this kind of investment calculation in a spread sheet (like Excell or QuattroPro).

I'd start with year number in the first column, calculate the return from previous years balance at the interest rate in col 2, put salary in next column calculated from previous years salary at raise rate shown, and then this years 5% contribution, and % employers match. Add up all of this years increases in a subtotal column if you like and then add them to last years balance at end of year to get the end of year value.

I would use the copy feature and a year no=last year no +1 and copy down for 30 rows to calculate year numbers.

Then once formulas are set up right in the first row, copy them down for all 30 rows to get your final number.

This essentially gives you a financial model of what the account should be worth (and what your salary should be) for the next 30 years. I did this back in 1983, and was surprised at how closely the real numbers tracked the calculation. It is fun to see if you are ahead of the curve or falling behind.

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Author: TwoCybers Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 67799 of 74759
Subject: Re: FV calculation help Date: 12/6/2010 2:40 PM
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Asumming all changes happen at the end of the year (lump sum payments from you and employer, investment returns and pay raises), one day before the end of year 1, your account is still worth $40,000. After a year and one day the value is $50,800. (The initial $40K, plus $4K from you and your employer. Plus $2,800 return on the $40K)

OK at the end of year 30, the total in the account will be $1,232,633 which really looks nice,

Before you start spending your retirement funds, a few sobering points.

#1 Returns are never x% a year -- year after year. Some are better and some are worse. 1929 was a bad year. 2008 was a bad year. 1932 was a great year. 2010 has been a good year. Just remember the story about the person who with a backpack full of rocks that decided to walk across a lake whose average depth was only 2 feet -- in the middle there was a section 8 feet deep.

#2 Inflation will happen. If for example we have really low inflation averaging 1% in 30 years a dollar will be buy goods and services worth $0.74 today. With 2% the dollar will be worth $0.54 and if we have 3% which is want many experts predict, it would take only $0.40 today to buy what will cost a dollar in 30 years.

#3 30 years in an eternity for predictions. Congress will make serious changes in tax laws and all kinds of things. One still should save, but don't let the power of compounding make you think you can cut your savings.

One approach is keep the savings up to your employer's match is used -- that is free money! A year or so down the road as you get that 2% raise, take 25% of your take home increase and save it. Do that with all new money. Then you have a cushion and maybe can even retire a bit earlier. Having that flexibility is something a whole lot of people who are say 55 today and lost there job really could use.

Gordon
Atlanta

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Author: pauleckler Big funky green star, 20000 posts Top Favorite Fools Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 67800 of 74759
Subject: Re: FV calculation help Date: 12/6/2010 2:56 PM
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The other thing to remember is that $1,232,633 is fully taxable at ordinary income tax rates (usually fed and state) unless you get a chance to convert to a Roth somewhere along the line.

The sum is subject to manadatory distributions at age 70-1/2.

So unless you have a magical tax strategy to avoid those taxes, its spending value in retirement should probably be reduced by 30% or so. And then you can factor in inflation (most expenses will double at least twice in 30 years).

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Author: Ripper14 Two stars, 250 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 67801 of 74759
Subject: Re: FV calculation help Date: 12/6/2010 3:01 PM
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pauleckler-

Thanks for clearing up my "duh" moment. I was trying to do it all in one cell using the financial formulas in Excel. Doing the calcs for each year takes care of the increasing savings problem, plus lets me track how close the actuals are to the estimates after however many years. Excellent idea.

-ripper

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Author: Ripper14 Two stars, 250 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 67802 of 74759
Subject: Re: FV calculation help Date: 12/6/2010 3:21 PM
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twocybers-

Good point on the lump sum thing. I guess if I wanted more resolution I could run it monthly rather than yearly, but I guess inter-year differences don't make too much of a difference to me right now because the salary increase and coresponding savings increase typically only happen at the end of the year (for me). I suppose this will underestimate earnings a bit because of the interest gained during the year, but conservative is better.

I hear you on points 1-3. I am shooting for 3-4M so I know I am quite short, but this instance is one of three accts I am working on so we'll see if I can get there. I hadn't heard the analogy you have in #1. That is great...I can use that in my job as we often work with averages. Regarding inflation, I'm assuming 3% in my final model, and only 2% wage increases so that will have me earning less close to retirement. Realistic? Maybe, maybe not, but conservative I hope. Thanks for the insights,
-ripper

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Author: TwoCybers Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 67803 of 74759
Subject: Re: FV calculation help Date: 12/6/2010 5:29 PM
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Ripper I do not claim to have magic vision - but here is how I approached this issue. I said I could withdraw somewhere in the range of 3.5 to 3.75% and adjust for inflation. Some people will say more, a few much more. In this area choices have consequences and running out of money or taking a serious income haircut above age 75 is not something I care to face. If my withdraw rate is too damn conservative great - I can buy more computers and donate money to whomever. If my withdraw assumptions are too aggressive, I will have lots of company.

You mentioned the lump sum payment assumptions I used - I am lazy. Yes your IRA contributions will happen through the year, but when that money is actually invested is another issue. There are studies that say putting money in the market at this month or that year in an election cycle gets you 0.X% more compounded return. In my view the assumptions have uncertainties, particularly out 10 years or more that greatly exceed any errors made by using annual vs monthly or even weekly payments.

Gordon
Atlanta

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Author: Watty56 Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 67804 of 74759
Subject: Re: FV calculation help Date: 12/6/2010 11:49 PM
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It wasn't clear if the 2% assumption about future pay raises was for inflation or increasing salary in real dollars.


If it wasn't for inflation then you might want to consider having a differnt rate as you get older. Many people have their real salary peak in their early 50's or so.

Greg

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Author: gdett2 Big red star, 1000 posts Old School Fool Ticker Guide Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 67805 of 74759
Subject: Re: FV calculation help Date: 12/7/2010 1:07 AM
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Ripper14,

After looking at your question, I believe you really need to look at a retirement planner.

The future value of an asset and income is pretty straight forward, but if you want to plan for the future, that is exactly what you need to do.

When I was 30 I did that. Needless to say the original plan did not work. I modified it as the years and jobs went by. At 55, my wife and I pulled-out and haven't looked back.

Initially, I wrote my own calculator on my 8 KB computer. It started my investing and saving. Later I used speadsheets and when Quicken introduced it's retirement planner, I knew I had the proper tool. I still use it to track how I am doing.

Using a tool like this allows you to have one place to manage all finances, loans and mortgages, savings and investments no matter what institution holds them. The planner module uses your live data as the base for your plan. You supply other assumptions, like the ones in your post, your life expectancy, estimate inflation, investment return, etc.

I will answer questions like, Am I saving enough. With money in an IRA, what will RMDs(required minimum distributions) do to my savings.

The true utility of this is the ability to model various changes. As your investments shrink and grow the changes are in your plan are shown. You can try different rates of return, inflation, savings rate, etc.

This also serves as a tool to assist in decision making. What happens if I buy that new boat? car? What effect will paying for college for the kids have? You can build in anything that can have a financial impact.

The earlier in life that you start to plan for your future makes it more attainable and better!

Gene
http://www.taylortel.net/~gdett2/

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Author: pauleckler Big funky green star, 20000 posts Top Favorite Fools Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 67810 of 74759
Subject: Re: FV calculation help Date: 12/7/2010 2:07 PM
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It seems to me, detailed modelling requires introducing the concept of tolerance.

When the first vacuum tube electronic computers were built, they were designed to work within the normal tolerances of the components used to build them. Your portfolio may average 5% return for life, but there may be time frames where it earns 10% or more and others where it loses money or earns much less. Inflation can be very low for a while, even zero, and very high at other times.

A really detailed model needs to factor these aspects in.

If you have followed Motley Fool or investing for a while, you know that the numbers we use today are very much influenced by recent events and numbers. The same calculation made every 10 years for the last 50 years probably would give wildly different numbers. This emphasizes that the best you can do is aim for the middle and build in some reserves--hoping you will be able to adapt to whatever comes up. Most estimates fail to take into consideration the magnitude of the variances.

My philosophy when I retired Jan 1, 2000, is I will try it based on what I know, but I won't be confortable until I have made it through one stock market meltdown and survived. This philosophy has served me well, because some of my estimates were right on target, but others missed quite a bit. Reserve assets over the minimum served me well.

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