A very simple calculation (for tough questions)
Excerpt adapted from the Book:
The Aspirational Investor by Ashvin B. Chhabra
A common but hard-to-answer question is: How much do I need to save for retirement? Though retirement may be your primary goal - THE GOAL! - this same calculation applies to any financial milestone or goal. Let’s break it down step by step.
Financial calculators often provide varying answers to the same question, such as how much you need for retirement. This is because although they all use the same methodology, they often differ on at least two important inputs:
- The estimated rate of return on investments.
- The discount factor used to determine present value of future cash flows.
Some calculators add a tax rate that changes over time and a life expectancy that changes as each year passes. They may also use Monte Carlo simulations to model thousands of financial scenarios—leading to a wide range of possible outcomes.
Instead, we’ll take a straightforward approach that offers surprisingly useful estimates for future financial needs.
How to Calculate Your Savings Needs: A Simple Method
- Estimate how much you would need if the goal were happening today.
- To illustrate, let’s use a simple example: saving for a down payment on a house
- If you plan to buy a home in the future, start by estimating how much that home would cost today. For instance, if an equivalent house costs $100,000 today, that’s the baseline amount you should account for in your financial plan.
Amount needed today for a future goal = Amount required to fund the goal today.
This approach assumes that the rate of return on investments equals the rate of inflation, keeping purchasing power constant. While not exact, this method provides a reasonable and intuitive estimate of future financial needs. If you don’t have the full amount saved yet, you can calculate the shortfall and plan accordingly.
Shortfall = Amount needed today - Amount currently saved for the goal
For example, if you need $100,000 for a goal but have saved $50,000, the shortfall is: $100,000 – $50,000 = $50,000
Each year, you should reassess this number based on:
- Investment growth: Did your savings increase?
- Contributions: Have you added more funds?
- Rising costs: Has the goal become more expensive due to inflation?
Annual Savings Needed = Shortfall / Number of Years Left
For example:
- You plan to buy a house in 5 years, but your shortfall is $50,000.
- To stay on track, you need to save $50,000 ÷ 5 = $10,000 this year.
- Next year, with only 4 years left, you’ll recalculate: $40,000 ÷ 4 = $10,000.
- This process continues until you’ve saved enough to meet your goal.
Of course, then you will have to make sure you have enough for many other expenses that come with owning a house– but that’s the subject of our next article (The Number) on further estimating expenses to meet your goals.