How Retirement Calculators Work

Published: September 1, 2012 at 2:29 pm

Last Updated on

Retirement planning is a complicated financial goal. When you save for a new car, exotic holiday or even for the education of your children, all or most of the accumulated corpus would get spent when the time for the goal arrives. So it is easier to calculate the corpus required for such goals.

When it comes to retirement planning the corpus calculation is complicated because the corpus does not get spent in one shot. Typically it is allowed to grow at some post-retirement interest rate (usually underestimated for safety) and monthly withdrawals are made from it. For complete financial independence during retirement, these withdrawals or pension must increase according to the post-retirement inflation rate.

So the retirement corpus calculation has to take into account not only the years to retirement, present inflation rate but also post-retirement inflation, number of years in retirement and post-retirement interest rate on the corpus.

Given these input parameters, retirement planning consists of two major steps.

1. Calculation of the corpus required:

(a) Compute projected future monthly expenses at the start of retirement. This amount can be taken as the initial monthly pension which will be withdrawn from the corpus.

(b) This monthly pension amount is assumed to increase every year according to the rate of inflation, while the corpus is assumed to grow at some constant interest rate. Using these inputs the corpus is calculated using Excel’s present value calculator (PV). The inputs to the PV function, the formulae used are a bit technical and can be found here.

Since the withdrawals are indexed to inflation, the corpus will decrease each year and become zero at the end of the retirement period given as input. A typical rise and fall of the corpus is shown here.

2. Calculation of the monthly investment amount required:

Once the corpus needed is known, this calculation is similar to any other financial goal. It uses the number of years to retirement, estimates of present inflation and annual interest rate, annual increase in investment if any, and amount accumulated so far if any.

The excel based calculators in this site does the above tasks and present an annual cash flow chart of the monthly investment made, monthly expenses, the growth of the retirement corpus prior to retirement and its decrease post retirement. Annual salary and its growth is also shown for reference.

First published at OneMint Thanks to Manshu author of OneMint for publishing this.

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