Question

To live comfortably in retirement, you decide you will need to save $2 million by the time you are 65 (you are 30 years old today). You will start a new retirement savings account today and contribute the same amount of money on every birthday up to and including your 65th birthday. Using TVM principles, how much must you set aside each year to make sure that you hit your target goal if the interest rate is 5%? What flaws might exist in your calculations, and what variables could lead to different outcomes? What actions could you take ensure you reach your target goal?

Answer 1

Answer: Please refer to Explanation

Explanation:

1) You want to have $2 million when you are 65 which is 35 years from now. The interest rate is 5% and you need to know how much to deposit per year to get to that level. The $2 million is therefore the future value of your contributions which makes this an Annuity.

To calculate for the Annuity amount use the following formula,

FV of Annuity = Annuity ( ( (1 + i)^ n -1 )/ i )

2,000,000 = A ( ( ( 1 + 5%) ^ 35 -1 ) / 5%)

2,000,000 = A ( (1.05^35 -1 )/5%)

2,000,000 = A (90.3203074)

A = 2,000,000/90.3203074

A = $22,143

You should set aside $22,143 every year.

2) The major flaw in the calculation is the assumption that the interest rates will remain the same over the 35 years. This is almost impossible and will affect the amount that would need to be deposited every year to achieve the target. If the interest rate should increase then it will increase the amount that you are to get meaning you can get more than $2 million then you would not have to deposit as much to get to $2 million. If it decreases however, you will have to deposit more to get to the required $2 million because the amount earned in interest will not enable you to get to $2 million in that timeframe. .