How to calculate your total future needs and retire early

In the latest of a series of articles, former lawyer and City money man Peter Alcaraz shares more advice on how to achieve financial freedom more quickly.

Peter Alcaraz read law and economics at Durham University and spent 24 years advising small and mid-sized companies on mergers, acquisitions, IPO's and fund raisings, first as a lawyer and for the last 20 years in corporate finance. At the age of 46 after reaching 'O' he left city life to write, study, travel and spend more time with his wife and two daughters. His first book, The Wealth Game - an ordinary person's companion was published in 2016 and has become a staple amongst wealth managers, business schools and private individuals wishing to develop their personal finance skills. 

Your net worth is a fixed number today, so to be comparable, your needs total must also be a fixed number in today's value. The difficulty is that your needs are uncertain and continue to the end of your life, so how can you quantify them?

The easiest way is to consider the categories in turn. Some can be calculated using a common approach; others have their own treatment. Certain cost categories, like food and energy, will run until you die; others, like school or child care fees, are for a few years only; some arise early in life; others arise later; and some expenses tail off, while others increase. At this stage keep the calculation as simple as possible.

• How you can achieve financial freedom more quickly
• How to calculate your real net worth

In my own planning and the analysis below, I assume life ends at 90, but it's up to you to set your own target. The major needs categories and approaches for capitalizing them are easy to apply to your life:

1. Accommodation

This includes your home(s), so places you live in or use rather than hold for investment or rental. A home is an absolute need; the scale or quantity is your choice.

Approach—First, ask yourself whether your definition of O includes a home that is owned or rented.

For an owned home, include today's market price of the type of home you expect to die in. I call this the final home value. Whether it is a £2 million or £200,000 home, include the relevant figure. The reason for setting the price at death rather than at some other point is that it allows you to assume that any excess value in property above this number is not a need but a source. 

The value of any home you currently own is irrelevant for this step. Once reaching O, however, you must recognize that if your home at that time is worth more than your then final home value, it will be called upon either through sale or equity release to deliver the surplus in cash at some point before death. The decision as to how and when you release any excess value will be for you to decide based on your circumstances and needs at the time.

Let's say that in calculating your needs today, you set a final home value at £500,000 but currently own a house mortgage free with a value of £850,000. For the calculation, your accommodation need is recorded as £500,000. If today is the day you reach O, you are effectively agreeing to release £350,000 in today's money at some time before death. 

If, on the other hand, you have no intention of moving house at any time before death, record your need as £850,000, which effectively becomes your final home value. The only point at which the question of final home value matters for real is when you reach O. Until then, it is an aspiration.

For a rented home, multiply rental costs in today's value by the number of years you expect to pay that rent. If you are 50 and expect to pay rent at £15,000 per annum for 30 years and then to downsize to a smaller place at £10,000 per annum for 10 years, the total is £550,000 (£450,000 + £100,000).

2.Subsistence living expenses

This includes food, utilities, and transport, plus any day-to-day expenses you consider to be essential, except those in other categories. If you need help calculating it, consult one of the many budgeting guides available.

Approach—Multiply today's annual total by number of years until age 90, so subsistence living expenses of £35,000 per annum add up to £1.4 million over 40 years. Alternatively, you can divide your remaining years into low, medium, and high spending periods to match your expected needs—for example, 10 years of high spending at £50,000 per annum; 10 years of medium spend at £35,000; and 20 years at a lower rate of £25,000, totalling £1.35 million.

3.Children

The day-to-day costs of feeding and clothing children should be included in the previous category. This section is for specific nursery and early-care charges, school and university fees, and financial support after leaving school. These involve personal choices that can have a big impact on outcomes.

Approach—Calculate total remaining costs for each child in today's money. How much, if any, do you expect to contribute to these categories? Nursery and early-care charges are hard to avoid, but from primary onward, the choice is between private or state-funded schooling. Similarly, the burden of university fees and living costs can either be added to your list of needs or shifted to the child to fund through student loans, part-time work, and later, full-time salaried employment.

The total cost of needs under this heading may be anything between £0 and £400,000* or more per child, depending on your decisions.

*Assumes private schooling at £8,000 per annum from age four to eight (£40,000), £24,000 per annum from age nine to thirteen (£120,000), £33,000 per annum from age thirteen to eighteen (£165,000) university tuition fees at £9,000 for three years (£27,000) and a £10,000 per annum living allowance for five years after leaving school (£50,000). This totals £402,000.

4. Holidays

This section refers to an allowance for all future holidays.

Approach—Multiply chosen annual cost of holidays by the number of years until age 90. Your holiday needs will change over time, as family numbers ebb and flow, your appetites evolve, and physical capabilities grow and decline. You can try to predict and cost these variations, but I prefer to start with the largest possible number and assume that you'll be able to spend it one way or another, whatever the circumstance. This way, any leftover is an upside. Include the cost of weekends away and short breaks as well as longer time out.

Over 40 years, an annual budget of £10,000 amounts to £400,000.

5. Cars

This section refers to the purchase cost of all cars you expect to buy in your lifetime.

Approach—One way is to multiply the cost of your chosen car by the number of upgrades you expect to make. For example, if you are running a 40-year forecast and expect to change your car every five years starting today, that's eight cars. If the cost of your chosen car today is £25,000, your needs are £200,000. Alternatively, list all the cars you think you’ll buy over the forecast period, including run arounds, luxuries, people carriers, vans, and off roaders, and add the total cost in today's money.

6.Maintenance or settlement obligations

This includes any known future obligations, such as payments to ex-partners for children, unless accounted for already.

Approach—Add up the total cost of future payments in today’s money. An obligation to pay £400 per month for 10 years amounts to £48,000.

7. Other luxury spending

This is where you can be as expansive or frugal as you wish. Though it's often hard to be specific, this category includes presents, pampering, and other nonessential items.

Approach—Include a monthly and annual budget for these things. An allowance of £500 per calendar month or £6,000 per annum over 40 years is £240,000.

8. End-of-life care

This includes an allowance for nursing and other care ahead of your death.
Approach—Add a provisional total sum. Let's say you are budgeting for yourself and a partner and want to allow £40,000 each. Include £80,000 in needs. Given the shifting nature of available care provision and its costs, this is a hard one to be clear on until you are well into the game, and even from the point of reaching O, it is certain to change again. The trick is to recognize your needs and include a reasonable estimate for it, based on circumstances today.

9.Fixed legacies

These are any specific cash amounts or appreciators that you want to pass on to beneficiaries on or before your death. By definition, like your final home value, these are ring fenced and, therefore, not available to service your needs between O and death.

Approach—Include today’s value of any such legacies. A legacy of £50,000 to each of your four children is a need of £200,000.

10. Miscellaneous needs

This section refers to any other needs not included in any of the previous categories. These can be entirely manufactured from a wish list of future luxuries. For example, life after O may seem pointless without a boat or a camper van or paid staff, so provision for these costs should be included. Similarly, you may feel the need to pay for private health insurance after a certain age, in which case the capitalized costs of this should also be included.

Approach—Add the item’s cost or capitalize as for other needs.

What about debt and related interest repayments? For many, the cash outflows for these are the dominant outgoing. In the wealth game, borrowings are treated as a source of funds to meet your needs rather than as needs themselves. These stand alone. Needs arise from your own physical requirements and wants, so they are quite distinct from the means you can muster to pay for them. Your job here is to cost your future needs, irrespective of how you fund them. Debt and its related costs are counted in the net assets side of the equation.

Adding the totals of these categories plus any others that you think apply gives today's value of your total future needs.

Depending on your age and choices, this may be a very large number. For example, an ambitious 30-year-old with a new family and home and forecasting 60 years to live will generate a much larger number than a steady 55-year-old whose children have left home and who is nearly mortgage free. And if today’s number is big, future values will be enormous if compounded over 15 years or more. One of the entertaining aspects of periodically running the numbers is watching your needs figure change as your tastes and outlooks mature or as your asset position firms up.

As you get older, your needs will become clearer, and your time periods will become shorter. What begins as a fairly rough-and-ready indicator with big risk around future assumptions gradually becomes a very reliable calculation. Clarity around the home you choose to live in, either rented or owned, and the number of children you parent helps greatly.

Here’s a very simple example for a 40-year-old with partner:

Final home value—£300,000

Subsistence income—£25,000 per annum × 50 years = £1,250,000

Children—2 × £75,000 = £150,000

Holidays—£8,000 per annum × 50 years = £400,000

Cars—10 over the remainder of life at £15,000 each = £150,000

Other luxuries—£10,000 per annum × 50 years = £500,000

Care—£40,000 per annum × 5 years = £200,000

Total needs = £2,950,000

This shows just how large the numbers can become for even a relatively modest lifestyle.

How does it compare to your current net worth? Through your decisions and actions, you have the power to expand or shrink your needs total by hundreds of thousands—if not millions—of pounds and set your rate of progress towards O. It is as powerful a force as your lifetime earnings, yet more under your control.

How does cash fit in? Find out next time…

Peter Alcaraz is a freelance contributor and not a direct employee of interactive investor.