Chapter 6 Personal nance

6.1

Introduction

We now look at some nancial planning models which incorporate exponential growth. The basic savings model can be varied to include factors such as regular payments in or regular payments out. We look at saving for retirement, where it is necessary to make a prediction of the savings required at the end of a working life, and hence establish the percentage of salary invested throughout the working life.

6.2

Saving for retirement

Let P (t) be the bank balance at time t, and suppose the account pays interest at a rate of r%. Then P (t + t) = P (t) + rP (t)t where rP (t)t is the interest earned in time period t. Hence we have d P (t) = rP (t) dt which has the solution (together with initial condition P (0) = P0 , P (t) = P0 exp(rt) 6.2.1 Example In the above setting, assume now that an amount W is withdrawn compounded continuously, and nd the dierential equation governing the balance. Solution Withdrawn compounded continuously means that we have another term W t, so P (t + t) P (t) = rP (t)t W t 47

CHAPTER 6. PERSONAL FINANCE As before, dividing by t and letting t leads to d P (t) = rP (t) W, where W is constant. dt

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6.2.2 Example: Systematic savings Peter starts working and plans to save 2000 a year, compounded continuously. Assuming that the interest rate is 5% compounded continuously, how much will be accumulated after 30 years? Solution Lets use 1000 as the unit of money, then d P (t) = 0.05P (t) + 2, dt P (0) = 0 (6.1)

d P (t) 0.05P (t) = 2. dt Using integrating factor exp( 0.05dt) we have d (exp(0.05t)P ) = 2 exp(0.05t). dt Integrating both sides, e0.05t P = 40 exp(0.05t) + C Using the initial condition we nd C = 40. Finally, dividing by exp(0.05t) gives P (t) = 40(exp(0.05t) 1). For t = 30 P (30) = 139.2676 Therefore Peter will have saved 139, 268 over the thirty year period. 6.2.3 Planning for retirement Peter decides he will need 50, 000 each year to live after retirement. He estimates that he might live for another 30 years after retirement. Assuming that the retirement account will earn 5% interest compounded continuously, how much money will Peter need in the retirement account when he retires?

CHAPTER 6. PERSONAL FINANCE Solution Solving as for equation (6.1), we have d P (t) = 0.05P (t) 50 P (0) = P0 . dt We need to nd P0 so that P (30) 0, to make sure the money lasts! Since P (t) = 1000 + C exp(0.05t), we have P (t) = 1000 + (P0 1000) exp(0.05t) Letting P (30) = 0, 1000 + (P0 1000) exp(0.05t) = 0 P (0) = P0

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This gives P0 = 776.8698, which means the initial balance has to be no less than 776, 870. 6.2.4 Saving for retirement Assume now that Peter wants to save a percentage of his salary into the retirement account. What value for will achieve Peters goal? Solution We have to make an assumption about Peters salary, starting say with 35, 000 per annum, and growing at a rate of 35 exp(0.04t), using the unit of 1000. Hence the amount in Peters savings account will be changing as follows: d P (t) = 0.05P (t) + 35 exp(0.04t), dt Using integrating factor exp(0.05t) leads to d (exp(0.05t)P (t)) = 35 exp(0.04t) exp(0.05t) = 35 exp(0.01t). dt Solving as for equation (6.1), we arrive at P (t) = 3500(exp(0.05t) exp(0.04t)). Supposing Peter is retiring in 40 years time. In order to reach his target he must save 3500(exp(2) exp(1.6)) = 776, 870 which gives = 0.091116871. This means that, based on the gures above, he has to save about 9.1% of his income. P (0) = 0.

CHAPTER 6. PERSONAL FINANCE

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6.2.5 The present value of money In the retirement story, we claimed that Peter will need an annual income of 50, 000 after he retires, though his starting salary is 35, 000. This may seem strange, but we have to take account of real purchasing power. Assuming that ination is running at 4% per annum compounded continuously, then to maintain the same purchasing power of 35, 000 forty years later, Peter needs 35, 000 exp(0.04 40) = 173, 356 That is, the equivalent salary forty years later would be 173, 000 in real purchasing power. So in retirement Peter is expecting less than a third of his starting salary. Vice versa, 50, 000 at his retirement is equivalent to present day purchasing power of 50, 000 exp(0.04 40) = 10, 095 Therefore money has dierent values at dierent times. It all depends on interest rate and ination.