Absolute planning gap

What Is Absolute Planning Gap?

The Absolute Planning Gap is a key concept in financial planning that quantifies the difference between an individual's or entity's anticipated financial resources and the total financial resources required to achieve specific financial goals. Essentially, it represents a projected shortfall or surplus at a future point in time. This metric is most commonly applied in the context of retirement savings, where it helps individuals determine if their current savings trajectory and expected investment returns will be sufficient to cover their desired lifestyle during retirement. Identifying an Absolute Planning Gap early allows for adjustments in budgeting, savings rates, or investment strategies.

History and Origin

The concept of identifying and quantifying a financial "gap" has evolved alongside the increasing complexity of personal finance and the shift in responsibility for long-term financial security. Historically, many workers relied on defined benefit plans, such as traditional pensions, where employers guaranteed a specific income stream in retirement. As economies evolved, and particularly with the rise of defined contribution plans like 401(k)s, individuals became more directly responsible for accumulating sufficient assets for their own retirement. This shift necessitated a more rigorous approach to personal financial projection.

The need for a structured way to assess future financial readiness became paramount, leading to the development of methods for calculating shortfalls or surpluses. Regulatory bodies, recognizing the growing importance of individual financial preparedness, have long championed investor education to empower the public. The U.S. Securities and Exchange Commission (SEC), through its Office of Investor Education and Advocacy, for instance, provides resources to help individuals plan for their financial futures, emphasizing the importance of understanding one's financial position and potential gaps.⁷, ⁸ This proactive approach to financial literacy underscores the importance of tools like the Absolute Planning Gap in guiding informed decisions about savings and investments.

Key Takeaways

• The Absolute Planning Gap is the difference between projected future financial resources and required future financial needs.
• It is a critical tool in financial planning, particularly for retirement, to identify potential shortfalls or surpluses.
• A positive gap indicates a deficit, meaning more resources are needed; a negative gap indicates a surplus.
• Calculating the Absolute Planning Gap requires clear assumptions about future income, expenses, inflation, and investment growth.
• Identifying an Absolute Planning Gap can prompt adjustments to savings rates, investment strategies, or lifestyle expectations to meet financial goals.

Formula and Calculation

The formula for the Absolute Planning Gap is straightforward:

Where:

• Required Future Resources: The total amount of money needed at a specific future point (e.g., retirement age) to cover anticipated expenses and maintain a desired standard of living. This often involves factoring in inflation to estimate the real cost of future expenses.
• Projected Available Resources: The total amount of money an individual is expected to have accumulated by that same future point, based on current savings, planned contributions, and anticipated investment returns. This calculation considers the effects of compound interest on existing and future savings.

Interpreting the Absolute Planning Gap

Interpreting the Absolute Planning Gap is crucial for effective financial planning. If the calculated Absolute Planning Gap is a positive number, it indicates a shortfall. This means that, based on current assumptions and plans, there will not be enough money to meet the defined financial goals. In this scenario, action is needed to close the gap. This might involve increasing savings contributions, adjusting asset allocation to potentially achieve higher investment returns, delaying the target date (e.g., retirement), or modifying the financial goals themselves (e.g., reducing future spending expectations).

Conversely, if the Absolute Planning Gap is a negative number, it signifies a surplus. While this is generally a favorable outcome, it can still prompt adjustments. A significant surplus might suggest that an individual could take on more risk assessment in their investments, potentially enjoy an earlier retirement, or allocate resources to other goals. It could also mean that initial assumptions were overly conservative, leading to unnecessary restrictions on current spending or too aggressive a savings plan. The interpretation always links back to achieving financial well-being, whether it's closing a deficit or optimizing a surplus.

Hypothetical Example

Consider Sarah, a 35-year-old aiming to retire at 65. Her primary financial goal is to have enough capital to generate an inflation-adjusted income of $70,000 per year for 25 years in retirement. She estimates she will need approximately $1.75 million in today's dollars to achieve this, but accounting for 3% annual inflation over 30 years, her Required Future Resources at age 65 will be roughly $4.24 million.

Currently, Sarah has $100,000 in her retirement savings accounts. She plans to contribute $1,000 per month and expects an average annual investment returns of 7%. Based on these projections, her Projected Available Resources at age 65 would be approximately $2.8 million.

Now, let's calculate her Absolute Planning Gap:

Required Future Resources = $4,240,000
Projected Available Resources = $2,800,000

Absolute Planning Gap = $4,240,000 - $2,800,000 = $1,440,000

Sarah's Absolute Planning Gap is $1,440,000. This positive gap indicates a significant shortfall. To address this, Sarah might need to increase her monthly contributions, re-evaluate her asset allocation for potentially higher returns (while managing risk assessment), work a few more years, or adjust her retirement spending expectations.

Practical Applications

The Absolute Planning Gap is a versatile tool with numerous practical applications across various facets of financial life:

• Retirement Planning: This is arguably the most common application. Individuals use the Absolute Planning Gap to determine if their projected retirement savings, including contributions to a defined contribution plan and other investments, will be sufficient to cover their desired expenses throughout retirement, considering factors like inflation and longevity. Studies have highlighted significant retirement savings shortfalls in the U.S., underscoring the necessity of such calculations.⁵, ⁶
• Education Funding: Parents or students can calculate the Absolute Planning Gap for future education costs, factoring in tuition inflation and projected savings from various accounts.
• Large Purchase Planning: For significant future expenditures like buying a home, starting a business, or making a major investment, the Absolute Planning Gap helps assess whether current savings and projected growth align with the required funds.
• Estate Planning: It can be used to determine if sufficient assets will remain to meet beneficiaries' needs or philanthropic goals after an individual's lifetime.
• Business Planning: Businesses may use a similar concept to project funding needs for future expansion, capital expenditures, or debt repayment, comparing projected cash flow against required capital.

Understanding this gap allows for proactive adjustments to financial strategies, ensuring that financial goals are achievable. It's especially crucial in dynamic economic environments where factors like inflation can significantly erode purchasing power over time, making it more challenging to cover essential expenses in retirement.⁴

Limitations and Criticisms

While the Absolute Planning Gap is a powerful financial planning tool, it is not without limitations and criticisms. Its accuracy heavily relies on the quality and reliability of the assumptions made about future variables. For instance, estimating future inflation rates, investment returns, and personal expenses over decades can be challenging. Unforeseen economic events, such as periods of high inflation or market downturns, can significantly alter projections and widen a seemingly manageable gap.², ³

Furthermore, human behavior can introduce significant variability. Behavioral economics highlights that individuals often make financial decisions based on biases rather than pure rationality, which can impact savings rates or investment choices.¹ For example, a lack of self-control or an overreliance on optimistic projections can lead to under-saving, despite a clear understanding of a planning gap. The calculation also tends to be static, reflecting a snapshot in time. Real-world financial situations are dynamic, requiring continuous monitoring and adjustment rather than a single calculation. It doesn't inherently account for unexpected life events like job loss, health crises, or significant family expenses, which can profoundly impact both required and available resources. Therefore, while providing a valuable framework, the Absolute Planning Gap should be viewed as a guiding estimate that requires regular review and adaptation.

Absolute Planning Gap vs. Retirement Savings Gap

The terms "Absolute Planning Gap" and "Retirement Savings Gap" are closely related and often used interchangeably, but a subtle distinction exists. The Absolute Planning Gap is a broader concept that applies to any specific financial objective where there's a need to compare projected future resources against required future resources. This could be planning for a child's college education, saving for a down payment on a house, or accumulating funds for a significant business investment. It represents the shortfall (or surplus) for any defined financial goals.

In contrast, the Retirement Savings Gap is a specific application of the Absolute Planning Gap, focused exclusively on an individual's financial preparedness for retirement. It calculates the difference between the capital needed to fund a desired lifestyle throughout retirement and the amount an individual is projected to accumulate in their retirement savings accounts and other assets by their retirement date. While the methodology is identical, the Retirement Savings Gap always centers on post-employment financial security. Therefore, every Retirement Savings Gap is an Absolute Planning Gap, but not every Absolute Planning Gap is necessarily a Retirement Savings Gap.

FAQs

What does a positive Absolute Planning Gap mean?

A positive Absolute Planning Gap indicates a projected shortfall. This means that based on your current savings, investments, and future plans, you are anticipated to have less money than you will need to achieve your specific financial goals.

How can I reduce a positive Absolute Planning Gap?

To reduce a positive Absolute Planning Gap, you can take several actions: increase your regular contributions to savings, aim for higher investment returns through strategic asset allocation (while managing risk assessment), extend your working years, or adjust your future spending expectations to lower your required resources.

Is the Absolute Planning Gap only for retirement planning?

No, while it's very commonly used in retirement savings planning, the Absolute Planning Gap can be applied to any significant financial goals, such as saving for a child's education, purchasing a home, or starting a business. It measures the difference between your projected resources and required funds for any future objective.

How does inflation affect the Absolute Planning Gap?

Inflation is a critical factor because it erodes purchasing power over time. When calculating the Absolute Planning Gap, future expenses must be adjusted for inflation, meaning you'll need more nominal dollars in the future to maintain the same standard of living. Failing to account for inflation will underestimate your Required Future Resources, leading to a misleadingly smaller, or even non-existent, perceived gap.

How often should I recalculate my Absolute Planning Gap?

It is advisable to recalculate your Absolute Planning Gap periodically, ideally annually or whenever there are significant changes in your financial situation (e.g., a raise, job loss, major expense, or change in market conditions). Regular review ensures your financial planning remains aligned with your evolving circumstances and goals.