Well, actually, I’d like to plan on being wealthy enough so that I don’t have to work. Leave the money making up to me. My question for all you people is how do I calculate the base investment needed in order to give me a modest $30K/year income in perpetuity. Or at least for the next, say, 50 years or so.
I’d want to adjust for inflation (ie, I want 30K a year in 1999 dollars), and I’d want to base it on fairly stable investments. How do I calculate the base amount of money needed to provide me my income, plus enough to re-invest so that said income is adjusted for inflation, etc?
And, btw, if anyone has that lump sum sitting around and wants to give it to me, that’s OK, too. Email me and I’ll give you an address to send it to.
Others may disagree with this, but I don’t think you need to worry about adjusting for inflation.
Why you ask? Because you will have a large sum of money that you plan on investing. Any sort of guarenteed investment should at least give you back enough money to cover inflation .
You want $30K/year for 50 years. That means you need an initial sum of $1,500,000. Lets assume 2% inflation, and that you take a guarenteed investment that pays 4%.
If you invest half of your initial sum ($750,000) this will exactly cover the amount of money you need to raise your “salary” by 2% every year for 50 years. But getting a guarenteed 4% is no problem so there is no risk.
Now, if you don’t want to invest any money you would need $2,537,000.
The big question is: is 2% a good number for inflation? That I don’t know.
Also, this doesn’t take into account the taxes you would have to pay on either the initial sum OR on your earnings if you go the investment route.
You can invest. However, that does not mean your investment is going to be stable, shoot, you could actaully have negative interest cause of the economy.
Choose a big bank, one thats going to be around a long time, especially after y2k.
I think I may have made a logical error in the first bit of reasoning (the investing reasoning). I got mentally onto a tangent of keeping your income at hand steady when in reality all you need to do is earn enough money to pay for next years pay raise (i.e. you need to make 2% of last years salary, or $600 the first year, $1212 the second year).
Clearly, at first earning the meager amounts you need are trivial, in fact with any serious amount of investing you would easily make enough money to cover the salary increases in later years. So, you still would be just fine with $1,500,000, but my reasoning as to why you would fine was flawed.
I tried plugging some numbers into Excel, but I’m little rusty at this. I came up with an initial investment of about $400,000, assuming an ROI of 7%. That would give you $30,000 a year for 50 years, with some change left over.
I believe the average rate of inflation is 3 to 4%, about the same interest you’d make if you put the money in a bank. Don’t keep your money in the bank! Diversify, diversify, diversify.
I’m a particular fan of real estate: in one year we’ve acquired several rental properties, increasing our net worth by $100,000. The properties pay for themselves plus produce a tidy profit- like having an extra paycheck each month. Eventually, when the mortgages are paid off, we’ll have $3,500 per month net profit in today’s dollars, but the rents will go up to adjust for inflation.
I would suggest putting part of your lump sum into high risk investments with a high return- say 12%, with compound interest so your money grows as fast as possible. Put a smaller part in safer investments that have a lower rate of return. As time goes on, move more of your money from the high risk/ high yield investments and into the safer ones. In the beginning, when you have plenty of time to make up any losses, riskier ventures make sense. Later you’ll want to be more conservative so you don’t risk losing more than you can afford.
By starting out with high yield investments you can make your money grow much faster and thus require a smaller initial outlay.
Well, I like the $400K number better than the 1.5 Million number. $400K is a possibility. 1.5 mill? I don’t know about that one.
I tried to figure out your numbers, Bernard, and I don’t quite understand them. 4% on 1.5 Mill is 60K, is it not? I only need half that.
I believe 4% is the number most financial analysts use for inflation. And I agree with Holly - the little I know about investing tells me that I could probably diversify and expect an average of 7-10% a year. 'Course, I’m no financial genius, but for those of you out there who are, is that not correct?
I guess I was hoping there was some set formula that said X amount in the bank has historically proven to bring an income of Y. Guess not, eh?
And Holly, I agree and disagee with you on the real estate thing. My own home has gone up $50-$60K in the two years I’ve owned it. However, in my area, I think it’s pretty hard to make money on rentals. When you add in the time & money you spend on 'em (looking for renters, fixing things, etc. etc.) it doesn’t look very profitable to me, unless you own enough property to do it full time.
Hmmmm… now just have to wait for those stock options to turn into 400K…
Assuming 4% inflation (which means that by year fifty your 30k per year budget has grown to $205,000 for that last year) and a 10% return (not unreasonable, but not ever guaranteed), and further assuming that you don’t draw your budget until the end of each year, $487,000 would satisfy your budget and even leave $31,616 so you can throw a good bye party for your friends at the end of year fifty. Not only that, but you’d be a millionaire between years 25 and 41. If you were to start with 500,000 however, “only” 13 k more, you’d still have 1.4 million at the end of year 50. (Much bigger party) 10% return might well be achieved by a simple S&P 500 index fund. Check out www.fool.com, those guys wax lyrical about this kind of stuff. Oh, and before you tell your boss to shove it, please check my math…
I thought about it over the weekend, and I came up with a slightly different answer.
What you’re looking for is to establish a principle that will provide you with $X/year in interest. Each year you withdraw the interest and leave the principle, protecting your investment.
Let’s say you need $30,000/year to be comfortable. That’s net, mind you. Now you have to add taxes, health and medical insurance (cos you’re not working, you have to provide for yourself), and a 4% inflation factor (this is a WAG). I figure you’ll have to gross $50 to 60K in interest to insure you have $30K after taxes, etc.
Now it’s just a matter of finding an investment with a guarenteed return, like CD or a bond. Take your annual estimated income, divide by the ROI of the investment vehicle, and voila! you have you minimum investment.
For example, let’s say you invest in 1 year Treasury bonds that have a return of 7%. That means you’d have to buy about $720,000 worth of bonds. There’s a little variation, because I think you get a tax break on interest from government bonds, but you get the idea.
Pretty straightforward spreadsheet: Column A is the year. Column B shows you what your $30,000 per year means when adjusted for inflation: you multiply 30,000 by 1.04 for year 2, multiply that by 1.04 for year three, etc. (fill down the sheet) Column C starts with a guesstimate in year 1 that you can later change to play endless hours of what-if, year 2 is the year 1 amount times 1.1 (10% return) less the amount spent in year 2 (from column B), copy down the sheet. You have a winning starting number if this column never shows a negative. I figure if you start with $487,000 at the end of year one it meets your original expectations. Of course, we are assuming steady 10% returns, and 4% inflation, but you can build the sheet for any assumption. Unfortunately, if you’re anywhere near human, you will likely find that after making the kind of money it takes to accumulate a half mil anywhere soon enough to warrant us doing the math for 50 years afterwards, you can’t live on 30k/year anymore…
The math:
Let’s assume that the rate of inflation is i %, expressed as a decimal such as 0.02 (for 2% annual inflation). So if you want $30K in year one, then you want $30K x (1+i) in year two. That is, if you think inflation will be 2%, then you want $30K x (1.02) for the second year.
Let’s also assume that you can find an investment that earns j % per year. I’m assuming that your $30K number is gross, you’ll still have to pay taxes on it. (If you want the net amount to be $30K, see note below.)
Now, it’s tough to write math formulas, but the critical number that you need is
(1+j)/(1+i) = 1+k. For instance, if i = 2% and j = 7%, then 1+k = 1.07/1.02 = 1.04902.
Then your formula for the amount you need today to provide $30K (inflation adjusted) each year for 50 years is:
You can set up a spread sheet to calculate this. Most advanced spread sheets will have interest or financial functions, and you can find this using Present Value functions (n = 50, int = k, BEGINNING of period). You’d need to check your calculator/spreadsheet, there are differences… test it out with n = 2, so you can multiply to check numbers.
So, for the set up as above, if you think inflation is 2% per year, and if you can earn 7% annual investment return, you would need $583,338 up front. That is, you would peel off $30,000 immediately; then the remaining $553,338 would earn 7% so $38,734, so that you’d have $592,072 at the beginning of the second year; you’d peel off $30,600 the second year (30 x 1.02) and the remaining $561,472 would earn 7% so $39,303 and you’d have $600,774 at the beginning of the third year; you’d peel off $31,212 and so forth.
If you think inflation is 3% per year, and if you can earn 7% annual investment return, k = 3.883% and you would need $683,069 to peel off $30K (inflation adjusted annually).
Now: Taxes.
If you want to adjust for taxes, and you think the tax rate is 20% (probably high for that income level), you would replace j as the investment return with 0.8 x j
I made some additional assumptions that you wouldn’t want to have your income in any kind of jeopardy. So I assumed that you would get a VERY low rate of return (a mere 4%). Plus to be extra safe I assumed you wouldn’t want to invest the whole thing because a bad year could wipe you out.
The calculations are extremely sensitive to the assumed spread between the interest rate (investment earnings) and the inflation rate (cost of living increases) – that’s k, in the formula I gave above. That’s why I cited the formulas, so people can figure out any variations.
There is also a slight difference on whether you take out the first $30K at the beginning of the first year, or at the end of the first year.
If you have an HP-calculator with interest functions, you’d put in factors for n =50, i = k (in my example), PMT = -30, and FV = 0 to determine the PV. If you have a spreadsheet that has financial functions, you can set the Present Value function similar.
If you have higher (or lower) expectations than $30K a year, just adjust the amount by the ratio. That is, if you want $60K a year, you need twice as much as if you want $30K a year.
“I made some additional assumptions that you wouldn’t want to have your income in any kind of jeopardy. So I assumed that you would get a VERY low rate of return (a mere 4%). Plus to be extra safe I assumed you wouldn’t want to invest the whole thing because a bad year could wipe you out.” ~bernard.
All investments carry some kind of risk. There’s no avoiding it; even if you bury your money in a jar in your yard, you risk that someone might dig it up and steal it. The lower the risk, the lower the return; having a low return is a risk in itself because you’re losing all the interest you’d have made if you invested at a higher rate.
Diversifying cuts your risk- if one of your investments does poorly, you don’t lose everything. This is why mutual funds are so great; if the market is terrible, the money you put in buys more shares of those cheap stocks. When the market goes back up (and it always does), you make scads of money off those stocks as they appreciate.
I still maintain that real estate is a great thing, provided you: 1.Live in an area where real estate is cheap enough for you to buy it but rents are high enough to make a profit, and 2.You’re willing and able to put a little elbow grease into it. We invested $22,000 to obtain $300,000 worth of real estate. The properties pay for their own mortgages, taxes, and repairs with $1,000 per month extra (plus some nice tax benefits). As they pay themselves off our profit will increase. Ten years from now they’ll be paid off and we’ll have $3,500 per month net income that will increase with inflation, plus we’ll have $300,000 worth of property (again, commesurate with inflation) that we can liquidate for extra cash.
I know that all investment carries risk, and about diversification, etc. However, for the purposes of this particular question if somebody were to come to me and say “I want guarenteed income, what should I do?” my reply would be “Get a low risk, low return guarenteed investment like government saving bonds for example.” It would not be a good idea, for example, to head to a casino, or play the futures market.
However, I will say that since this is a long -term investment it probably is safe to invest in something like mutual funds, since over the long haul they tend to go up overall (don’t forget to switch to a low risk venture later; however, since it is difficult, if not impossible, to do accurate predictions over the short-term).
Generally, simple mathematical modelling cannot take into account variation in investment returns in these type calculations. Such assumptions involve much more complicated mathematics than can be done in a simple spreadsheet or on a calculator with financial functions.
The calculations are still reasonably close if you assume that you can AVERAGE an annual rate of return of i % over a 50-year period. Thus, the first year you might have more and the second year less than i %, but the calculations are still reasonable estimates if the average over many years is at i %.
Most large insurance companies will sell annuities – you pay a fixed amount today (like $500,000) and they will pay you $30,000 a year (inflation adjusted) for the rest of your lifetime… or for 50 years… or whatever you’d like. Generally, such purchases are not a good investment strategy – you can usually do better than what the insurance company will credit your account.
However, the insurance annuity provides the certainty (since it is insured) of fixed payments over the contractual time period. Many individuals like to have their retirement accounts converted to an annuity that will pay a set amount (such as the $30K example) for their lifetime following retirement. Many companies’ retirement plans insist on such a method of payment.
Worth the reminder that our calculations are based on a hypothetical, and reasonable assumptions about tax rates remaining fixed in the future, etc. We’re setting up a model of how much you would need (minimum) to invest to be guaranteed $X annually for 50 years, we’re not suggesting investment vehicles to do that.
Bottom line: the rich get richer and the poor get poorer. But in the meantime…
What? You mean I can’t sue you if this doesn’t work? (lol!)
Now all I gotta do is come up with the seed cash. Interestingly enough, although many of you were generous with advice, not one person offered any cash. Bummer. Guess I won’t give up the day job anytime soon.
The best piece of advice I could give anyone is to live below your means in your earlier years (ages 20-30). The natural tendency though, is to live at the highest standard you can afford at any given time (the biggest house I can afford right now). Belive me, it will pay off in later years. I know, because I’ve made all the mistakes, and now it’s too late to catch up, unless I come up with a killer get-rich-quick idea.
The best investment is income property (rental), the worst is your typical 30 year home mortgage (you’re going to pay for that house 3 times over). If I had it to do over again, I would have lived in a small trailer on a big piece of property, and continued to add rental units over the years, until now I could retire on the income from the rentals (and have a really nice house built to boot).
I see it all the time here in NC with the aerial mapping I do, big fancy house with circular drive and pool, and surrounded by acres of mobile homes, obviously part of the same property. It doesn’t have to be mobile homes, mind you. Starting with a duplex is a good idea (the renters pay half the mortgage for you!).
