Back to: Money Master 2018

In a previous section, you worked with the retirement calculator shared with you. And it looks quite complex, doesn’t it?

What if I tell you that almost all of that retirement calculator is made using Present Value, Future Value and PMT formula in excel that we looked at in the previous lesson.

Yes, that’s right.

Now, it’s time for you to know too.

Let’s see how does that calculator work to calculate your retirement fund need. And how have the PV, FV and PMT functions been used there.

Heading back to the calculator again.

**Watch the following two videos**.

The **first video** takes you through how much you need to save for your retirement.

**Video length**: 16.5 minutes approx.

The **second and the final video** takes you through the creation of the retirement fund.

**Video length**: 8 minutes approx.

Download Retirement Planning Calculator sheets used in the video

Do you feel confident with the use of financial formula? What day to day scenarios do you see them using immediately?

Go ahead and build your own small calculator for any goal that you have and share here.

Amit Srivastava says

Hi Vipin,

Thanks for putting up these videos. This really helped me understand the nuts and bolts of the retirement calculator. I feel more confident with the concepts (and numbers) now.

There’s one thing that is bothering me and that is the calculation of effective/discounted rate. If I hadn’t gone through this lesson and someone told me that the expected rate of return on the investment is 9% and inflation is 8%, I would have simply assumed that the net rate of return is 1% (9-8).

Glad that I am doing Money Masters!

I tried to research a little to understand the concept of effective/discount rate but couldn’t find anything relevant (though I haven’t spent a lot of time yet). I tried to visualize in my mind by applying the rates in succession, but then it didn’t match with our calculations (and then the question of which rate to apply first as the order will impact the result).

I passed the quiz by simply reusing your formula. But I want to understand it better.

If you have any references/ links related to this, please do forward.

Cheers,

Amit

PS: I swear I have a B.tech degree 😉

Vipin Khandelwal says

Hi Amit

I am glad you realised the benefit of being in the Money Master program.

On the effective rate thing, the simple principle to understand is that in the same period of 12 months or 1 year, 2 things are happening. The growth of x% and the inflation of y%. So, a Rs. 100 is being pulled forward by the growth, but backward by the inflation. And that is the essence of the equation too.

I have personally not come across any external content on this, but this is probably the most rational way to think about it, at least in my view.

We can look forward to views by other members as well.

Thanks again. And I have no doubt you have a B.Tech. Your questions and doubts prove that.

All the best!

Amit Srivastava says

Thank you for the explanation Vipin. This is helpful. I will try to find more about this. Maybe, revisiting interest rate basics might help.

Cheers,

Amit

Vipin Khandelwal says

Nice to know you are embarking on a discovery.

Amit Srivastava says

Ok. So this thing was really bothering me and I finally managed to find some time to understand this better. Unfortunately, I couldn’t find any piece of content that explains this in a simple manner. I’ve tried to put pieces together and I am writing this long comment just to clarify my own understanding (and hopefully help someone else who is stuck on this). So here’s how it goes:

Generally, if you have multiple interest rates coming into play, one would apply them one after the other (order doesn’t matter) to come up with the ‘effective’ rate of interest. Let us assume that the two rates are R1 and R2. Our principal is P. Let us assume that our ‘effective’ rate of interest that we earn is Re. The following equation holds:

– P(1+Re) = P(1+R1)*(1+R2) => Re = (1+R1)*(1+R2) – 1

This is the formula that we used to calculate the second effective rate in the retirement planning tool (row#29).

Now, I would have hoped to use the same formula to calculate the effective rate of interest in the first case. Just that we would have used a -ve sign for inflation. Assuming R as the rate of investment return, i as the inflation and Re as the effective rate of return. The formula should have looked like:

– P(1+Re) = P(1+R)(1-n) => Re = (1+R)*(1-n) – 1

But this is not the formula that we have used. And this is what has been bothering me. Following is what I have come up with after going through some material on the web:

Inflation is a different monster altogether. And we should not treat inflation just like any other interest rate. In the retirement planner, what we are trying to calculate is our REAL rate of return, considering the inflation. I will make some real assumptions here:

– Inflation (i) = 8%

– Rate of return on our investment (R) = 9%

– Let us assume that our principal (P) is Rs. 100

So we all know that inflation pulls down our ‘purchasing power’. To understand this better, just imagine that we are trying to calculate our REAL increase in ‘purchasing power’. Isn’t this what ultimately matters? Let’s explore further:

– Let us assume that the cost of 1 unit of our favourite chocolate that we want to purchase today is Rs. 100

– Since inflation eats into our purchasing power, we will need Rs. 108 (=P(1+i)) to purchase one unit of the same chocolate one year down the line.

– And since we invested our money @ 9%, at the end of one year we have Rs. 109 (=P(1+R))

– So, how many units of chocolates can we purchase one year down the line with Rs. 109? This would be the money we have divided by the unit price = (109/108) = P(1+R)/P(1+i) = (1+R)/(1+i) = 1.0093.

– So how many additional units can we buy one year down the line? = (1.0093 – 1) = (1+R)/(1+i) – 1 => (do you recall something?)

– This means that we can buy an additional 0.0093 units one year down the line. Precisely, this is our increase in purchasing power. THIS IS OUR REAL RETURN. In terms of percentage, it is 0.93%.

This is the reason what the formula to calculate the real rate of return is: Re = ((1+R)/(1+i) – 1)

Apparently, this is the Fisher Equation proposed by a gentleman named Irving Fisher (https://en.wikipedia.org/wiki/Fisher_equation). BTW, the wikipedia article went over my head.

Lesson learned: While compounding can do wonders to our returns, inflation can do a lot more damage than we can intuitively imagine. So we should really look to beat inflation hands down!

And Money Master will help us do that!

Vipin Khandelwal says

If there was a purpose to Money Master program, it has been achieved today. I am so glad and so happy Amit that you went down the rabbit hole and figured this whole thing out. I wish I could put the badge on you, right now.

Thank you for this. You made the whole thing worthwhile.

I am sure this effort will encourage other members too to see Money Master in a whole new light.

All the best!