Last Updated on February 12, 2022 at 6:15 pm
If you do not like to do complex financial planning calculations, here are some interesting and easy to use back-of-the-envelope financial planning calculations!
About the author: Swapnil is a SEBI Registered Investment Advisor and part of my list of fee-only financial planners. You can learn more about him and his service via his website Vivektaru. In the recently conducted survey of readers working with fee-only advisers, Swapnil has received excellent feedback from clients: Are clients happy with fee-only financial advisors: Survey Results. His story: Becoming a competent & capable financial advisor: My journey so far.
As a regular contributor here, he is a familiar name to regular readers. His approach to risk and returns are similar to mine, and I love the fact that he continually pushes himself to become better as you see from his articles:
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Back of the envelope financial planning calculations: During the recurring NISM investment adviser level 2 exam this year, I detested doing financial planning calculations required for case study questions. The longer I am working as a financial planner, the more I am realizing weaknesses of financial planning calculations that rely heavily on assumptions about the future.
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Financial planning calculations are based on the belief that the financial planner or the investor can predict the rate of inflation, return from equity, return from debt, return from other assets like real estate and gold, the percentage increase in savings each year, etc. None of us can predict any of these in advance. We don’t follow the assumed asset allocation, nor do we rebalance portfolios with assumed frequency.
These assumptions are also linear. In the real world, returns fluctuate, and so does inflation. We may get caught in a bear market mega-trend unusual in its longevity. Standard financial planning calculations cannot handle such mega-trends.
Our financial goals are only guesses at the financial needs of our future selves. A 35-year-old cannot predict his annual expense at age 60. His 60-year-old self is a stranger to him today. Most of us have little idea which field our children would opt for their higher education and the amount required for it.
Another problem is considerable variation in the output with minor differences in assumptions. Let me show this problem with the help of the freefincal robo-advisory template. The robo-advisory template is the best financial planning tool we have in India. It uses the bucket strategy for retirement corpus calculation and comes with predetermined inputs and assumptions.
Suppose three financial planners use the robo-advisory template for retirement corpus calculation of a 35-year-old who wants to retire at age 60 with 1 lac monthly expense in the present value. All three planners use default assumptions (e.g. 10% post-tax return from equity, 7% return from fixed income etc.) except inflation.
The first planner believes that inflation before and after retirement would be 8%. The robo advisory template calculates retirement corpus of 26.65 crores at age 60 for 30 years in retirement. The second planner assumes 7% inflation and gets ₹18.67 crore corpus requirement. The third planner gets retirement corpus of ₹13.11 crore with his 6% inflation assumption.
Remember, all three planners are using the same tool with the same assumptions for all parameters except inflation. The first planner would ask this 35-year-old to accumulate more than twice the corpus calculated by the third planner and ask him to save a significantly higher monthly amount compared to the third planner. Let inflation and interest rates change over the next few years and these same planners would change their assumptions, which would considerably change retirement corpus and monthly savings numbers.
Numbers like 26 crores, ₹18 crores, or ₹13 crores 25 years into the future make little sense to us because our brain is not wired to understand future values. We can only understand numbers in the present value. Future values have significantly lower utility than most of us believe.
No matter how advanced the financial planning calculator, the quality of its output depends on the assumptions about the future; and none of us has any ability to predict the future.
When highly advanced financial planning calculators can only give imperfect answers, why not use a simpler method? I call it back of the envelope method of financial planning calculations. SEBI RIA Avinash Luthria of fiduciaries.in introduced me to it.
In this method, we do all calculations in present value. The only two assumptions here are that our portfolio will generate the post-tax return matching inflation and we would increase our annual savings with inflation. We don’t need to predict inflation in this method if we take money management one year at a time and do these calculations once every year.
Before proceeding further I suggest you check this article Fee-only advisor Avinash Luthria warns real investment returns will be zero! Let us first take a simple example of how these calculations work.
Scenario 1: Suppose you need 20 Lac in present value for your Kid’s higher education after 10 years.
| Amount required in present value – a | 20,00,000 |
| Years to goal – b | 10 |
| Annual savings required in present value – c (a/b) | 2,00,000 |
| Monthly savings required in present value – c/12 | 16,666 |
Scenario 2: Suppose you need 20 Lac in present value for your Kid’s higher education after 10 years and you have already allocated 5 Lac towards this goal.
| Amount required in present value – a | 20,00,000 |
| Existing assets allocated towards the goal – b | 5,00,000 |
| Gap – c (a–b) | 15,00,000 |
| Years to goal – d | 10 |
| Annual savings required in present value – e (c/d) | 1,50,000 |
| Monthly savings required in present value – e/12 | 12,500 |
After one year, if you find that the amount required in present value is 21,00,000 and not 20,00,000, you take 21,00,000 as the amount required and repeat the calculations to get an idea about the savings required over the next one year. This adjusts calculations to account for the actual inflation. Keep doing this every year and you would achieve your financial goal.
We don’t assume any asset allocation of the portfolio and difference in the portfolio return that may cause. Asset allocation is determined and changed based on the time horizon of the goal and risk tolerance of the investor. We accept the return we get and assume that the return would match inflation in the future.
Investors who get higher returns from their portfolios would need to save lower amounts in subsequent years than investors with lower portfolio returns.
Calculation of retirement corpus
If we assume that the post-tax real return (return over inflation) from retirement corpus in retirement would be zero,
Retirement corpus required in present value = Annual expense in present value in retirement * Years in retirement.
| Annual expense that will persist in retirement in present value – a | 12,00,000 |
| Years in retirement – b | 30 |
| Retirement corpus required in present value (a*b) | 3,60,00,000 |
We can appreciate the 3.6 crore number in present value better than 26 crore, ₹18 crore, or ₹13 crore retirement corpus numbers in future value. We can then calculate the savings required for the retirement goal as follows.
| Retirement corpus required in present value – a | 3,60,00,000 |
| Existing assets allocated towards retirement – b | 60,00,000 |
| Gap – c (a – b) | 3,00,00,000 |
| Years till retirement – d | 25 |
| Annual savings required in present value – e (c/d) | 12,00,000 |
| Monthly savings required in present value – e/12 | 1,00,000 |
If you cannot save and invest 1,00,000 every month towards your retirement goal, understand that you cannot afford a lifestyle costing 12 Lac annual expense in present value in retirement. You must reduce your expectation and pray that your portfolio generates a higher return than inflation.
In no situation should you take higher allocation to equity to compensate for the lower savings potential. Asset allocation should be strictly based on the time horizon of the goal and your own risk tolerance. The corpus you accumulate determines the amount you can spend on any goal, not how much you want to spend.
If you are already retired, you can divide the retirement corpus by years in retirement to get an idea about the expense you can afford in any particular year in retirement.
| Retirement Corpus – a | 2,00,00,000 |
| Life Expectancy – b | 90 |
| Current Age – c | 65 |
| Years in Retirement – d (b-c) | 25 |
| Annual expense you can afford over the next one year (a/d) | 8,00,000 |
If you believe in the unified portfolio approach, you can add the present value of all financial goals, subtract the present assets that can be allocated for goal planning and divide the number by the number of years till retirement.
Here is how unified portfolio calculations work.
| Emergency Fund | 5,00,000 |
| Car Purchase | 10,00,000 |
| Higher Education – Kid | 30,00,000 |
| Marriage – Kid | 15,00,000 |
| Retirement | 3,60,00,000 |
| Total amount required in present value – a | 4,20,00,000 |
| Existing assets that can be used for goal planning – b | 60,00,000 |
| Gap – c (a – b) | 3,60,00,000 |
| Years till retirement – d | 25 |
| Annual savings required in present value – e (c/d) | 14,40,000 |
| Monthly savings required in present value – e/12 | 1,20,000 |
In the unified portfolio approach, you manage the liquidity of the portfolio and asset allocation. Back of the envelope calculations can give you an idea about the affordability. If monthly savings required is more than your savings potential, you cannot afford all your financial goals.
You can also do calculations for two portfolio approach (short-term and long-term portfolio) which I prefer. To calculate annual savings required for short-term goals, we add the present value of all short-term goals, subtract the amount already allocated towards short-term goals and divide by years till the farthest short-term goal. Similarly, we can calculate the annual savings required for long-term goals. In this case, we divide by the number of years till retirement. I will write about this approach in more detail in some other article.
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Those interested in the robo advisory template can check out some of its abilities here: Key features of the freefincal robo advisory software template
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