Retirement planning is all about figuring out how much money you need to stow today in order to meet your needs tomorrow. It can feel like a daunting task, but it's easier when you know how to make some simple calculations.
Calculating the "present value" of your money plays an important part in your retirement planning. Put in simple terms, the present value represents an amount of money you need to have in your account today to meet a future expense or a series of future cash outflows, given a specified rate of return.
- The present value of your money is the amount you need to have in your account today to achieve a specific savings goal in the future.
- To calculate present value for retirement, calculate how much retirement income you will need in addition to other income sources like Social Security.
- Consider your potential rate of return and your family and personal health history when calculating present value.
- Microsoft Excel has a present value (PV) formula to help you with calculations.
Calculating Present Value
If you need $200,000 in your account 10 years from now, the present value, or the amount you need to start with today, changes based on various assumed rates of return:
- If you earn a 3% return, you'll need $148,818 to start.
- At 4%, you'll need $135,112.
- If you get a 5% return, you only need to start with $122,782.
You can do these calculations on an HP12C calculator app or any other financial calculator app that you can download to your smartphone or tablet. You can also find financial calculators online.
Use these entries to do the calculations:
- N (number of periods) = 10
- I (interest) = rate of return
- PMT (periodic payment) = 0
- FV (required future value) = $200,000
- Then hit PV (present value) to solve for present value.
This simple present value calculation shows you that the higher the rate of return, the lower the amount needed today to fund your future expenses.
To achieve a higher rate of return, you must typically choose a riskier portfolio, which means you have the chance of a higher return but no guarantee. If you want a future value that has more certainty, you must accept a lower rate of return, which means you'll need more savings in order to provide enough money for the same standard of living.
Retirement and the Unknown Time Horizon
Suppose you know that in order to live comfortably in retirement, you'll need $20,000 per year in addition to your Social Security income. How much do you need to save to provide the $20,000 a year? A present value calculation gives you the answer.
To do this calculation, you now have two unknown variables: the rate of return and your longevity. The table below shows the respective present values taking both variables into account. In the table, you see the range of results:
- If you live for 20 years and can earn a 5% rate of return, you'll need $261,706 to provide you with $20,000 a year.
- If you live 30 years and earn a 3% rate of return, you'll need $403,769.
If your family and personal health history indicate you may be long-lived, you'll need to save more and/or work longer than someone with a shorter life expectancy.
|Present Value of $20,000 Per Year Income Stream|
|Return||20 years||25 years||30 years|
How to Use Present Value in Retirement Planning
Use the present value concept now to give yourself a rough idea of the amount of money you'll need to have saved at the start of retirement to meet your retirement spending needs. You can do this calculation and planning regardless of your age. The younger you start, the less money you'll need to save at any interest rate because of the power of returns that will compound over the years you hold your investments.
Start by adding up your anticipated annual expenses. Then, subtract out your anticipated fixed sources of income such as Social Security, determine how long you think you could live, and calculate the present value of that stream of expenses. Compare that to what you now have saved—or what you think you'll have saved by your retirement date—and you'll have a rough idea of whether you're on track or not for your savings goal.
An Annuity Investment Example
Suppose, for example, that you want to guarantee that you'll receive $2,000 each month ($24,000 per year) in retirement on top of your Social Security income. You decide that you want a conservative investment, so you choose to invest money into an annuity that will make payments each month to you for the rest of your life once you retire.
Assume that your annuity grows at a rate of 3.5% annually. You would need to deposit $456,858 today (present value) in exchange for the security of your $2,000 monthly payment for 30 years. By choosing higher-risk investments, you could earn a higher return on your money, but this deal may sound great to you if you value a low-risk investment and anticipate living a long life.
Other PV Applications
There are a number of ways you can apply present value calculations to your retirement planning.
Calculating Present Value in Excel
When using a Microsoft Excel spreadsheet, you can use a PV formula to do the calculations for you. The formula menu has a PV function with an interface that will ask you for the rate, total number of payments, the amount of payment, future value, and whether payments should be applied at the beginning or end of a period.
Present Value of Your Social Security Benefits
Present value calculations are the best way to compare one Social Security claiming choice to another. Many online Social Security calculators use this methodology and do the calculations for you. This can help you visually see which choice is worth more to you over your expected lifetime.
Present Value of Pension Options
A present value calculation is also an effective way to compare different pension choices. If you anticipate a long life expectancy, one option may be worth more to you in terms of present value than another option. If you are married, you ought to consider joint life expectancy in your calculations.
Frequently Asked Questions (FAQs)
How do you plan for inflation in retirement?
There are several ways you can plan for inflation in retirement. Maximizing your Social Security benefits is one of the best ways to plan for inflation since inflation adjustments are automatically worked into your payments. You can also shift more of your investments to assets that perform well in inflationary environments, such as TIPS, real estate, and blue-chip stocks.
What rate of return should you use when planning for retirement?
Your expected rate of return will depend on your investment portfolio. Consider the indexes that your portfolio most closely resembles, such as the S&P 500 or the Bloomberg Barclays Aggregate Bond Index. Don't forget to account for inflation if you're looking at a simple annualized return for the index.