You've probably heard about this before, but I have to mention it because of how important it is. Unless you know without a shadow of a doubt that you're going to be financially independent your entire life, and have millions and millions of dollars by the time you're 50, you want to be saving for retirement. Retirement is actually much more expensive than most people believe.
Right now if I gave you a million dollars, do you think it would last you 20 years? Well, $50,000 a year for one person, ya probably. What if I gave you a million dollars in 30 years, do you think it would last you 20 years? How about 40 years from now?
When we start thinking about this, we start thinking about the time value of money. If you're unfamiliar with this concept, check out this link posted by an elderly man about the prices he remembers from the 50s - https://nostalgia049.wordpress.com/2010/01/06/1950s-prices/. From this post we see prices like a 25 cent milkshake, 60 cent ham and cheese sandwich, and 24 cents for a gallon of gas. As time goes on and more money is printed, the value of the dollar decreases. This is also why we can't just print money to take care of our financial debt.
Back to you not running out of money
Let's calculate how much money you would have in retirement with the previous three scenarios. For this formula we need the discount formula to calculate how much $1,000,000 is worth in x years. We'll use the average inflation rate for our discount rate. The formula is PV = FV/(1+r)^t
20 years:
PV = $1,000,000 / (1+.03) ^ 20
PV = $553,675.80
30 years:
PV = $1,000,000 / (1+.03) ^ 30
PV = $411,986.80
40 years:
PV = $1,000,000 / (1+.03) ^ 40
PV = $306,556.80
So, think about your current lifestyle. Could you live for 20 years doing the things you want to do with $15,000 a year? You could probably live on that, depending on your expenses, but you would certainly be limited in the things you can do in retirement.
Fortunately, it's rather easy to combat the effect of the time value of money. You can do this by starting to let your money grow for you. Assess your level of risk and invest your money into bonds, CDs, stocks, or derivatives depending on your experience and risk. Obviously if you earn 3% a year, you in theory would have exactly the value of $1,000,000 today when you retire. However, if you're able to grow your money an honest 5% a year until you're retired you would have the equivalent of the following amount in today's value:
20 years - $1,485,947.40
30 years - $1,811,361.58
40 years - $2,208,039.66
Clearly this is much better than if you let the money sit and lose its value.
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Good post, I've often thought about doing a whole post on inflation myself, since I'm shocked that noone seems to really grasp this. A few say they understand, but you've really laid it out in concrete terms.
Who knows that could turn out to be conservative.
Meanwhile unfortunately for savers, yields are being suppressed. So unless you have a bit of financial education, the average guy will be hard pressed to get that 5% yield. In your projections over half of his wealth will be transferred to banks and the government.
Hopefully more people read your post!
Thank you, I appreciate it. I hope that more people look into financial concepts such as this, whether it be through myself or other mediums. There's so many simple steps that people can take to greatly improve their financial futures.
I find retirement calculators usually have 2 major flaws:
1.) They make you calculate how long it will take you to retire based on INCOME instead of SPENDING
2.) They make no mention of how to invest that money or how a nest egg grows.
The simple answer to both of these questions is The Trinity Study. The Trinity Study introduced the 4% Rule of Thumb - in short a portfolio of 80% stocks and 20% bonds allows you to withdrawal 4% a year to live on and has an 85% chance of success (still having money in it) after 30 years.
Thus, to estimate how much you would need to retire, you need to know how much you spend - if you spend $40k/year, you need $1 million.
The beauty of this formula is that inflation IS INCLUDED! A split of 80/20 stocks and bonds will yield average returns of between 6-8%, allowing for 2-3% inflation and 4% living expenses taken out.
The Trinity Study and 4% Rule of Thumb are easy to understand and much more straightforward than most retirement calculators/formulas.
The most important thing is is to give people somewhere to start - having to fill out a list of math problems is the nail in the coffin for retirement planning - an already painful process for many people.
The 4% Rule isn't foolproof- there's room for failure and it takes monitoring and adjustments to completely make it work. But those adjustments come DOWN THE ROAD, not before you've even gotten started. And for most people, figuring out where to start is the hardest part.