Can You Trust Retirement Calculators?

September 26, 2011

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Note from dshort: Yesterday I had an interesting phone conversation with Todd Tresidder, the founder of FinancialMentor.com, about retirement planning and the way people have been reacting to the global and personal financial stress of recent years. In the wake of that conversation, it seemed appropriate to repost his fascinating perspective on retirement calculators.

It’s time for the truth about calculating how much money you need for retirement. Finding the answer isn’t as simple as it appears on the surface. Sure, retirement calculators are easy to use. Just input a few assumptions about the future and your computer instantly provides the magic number. It’s only when you dig deeper that you find the problems. Input the wrong values for the impossible-to-make assumptions and your number will be dangerously wrong, jeopardizing your retirement security.

Let me be clear. Retirement calculators are valuable tools when used properly. I don’t oppose the use of retirement calculators — just the misuse of them — which occurs more often than not.

Every day people are betting their financial future on fictitious output based on assumptions that have almost no chance of being accurate. They mistake the retirement roadmap for the territory. They are misled by the scientific fa?ade that surrounds computerized calculators.

Don’t be deceived. The output is only as accurate as the assumptions used for input. One mistaken assumption and your retirement needs could easily be twice the amount estimated (or worse) leaving you financially exposed when you can least afford it.

What does this mean for you? Let’s dig deeper into retirement calculators, how they work, their limitations, and proper application so that you can see how to apply this valuable tool correctly.

How Retirement Calculators Work

Sooner or later everyone confronts the question, “How much money do I need for retirement?”

Whether you seek your answer from a local financial planner or do-it-yourself with an online retirement calculator will make little difference. Both paths will result in the same destination – a simple algorithm that projects your future investment growth and expenses based on a required set of input assumptions.

It is just simple algebra.

In other words, all retirement calculators use the same base assumptions to work their magic — retirement age, life expectancy, inflation, investment return, portfolio size, and expected retirement expenses. Some calculators will require more information depending on their sophistication. Others will work with less information because they assume answers to some of these inputs.

The point is the math is the math. They are all calculating the same thing in roughly the same way using roughly the same input — which takes us to our first deception when using retirement calculators…

The Assumptions Are Critical — Not The Calculator

Many articles are written discussing which retirement calculator is best. Heated discussion in forums has erupted over this issue.

Unfortunately, these discussions miss the point because the critical factor to the accuracy of your retirement estimate is not the calculator used, but the assumptions used by the calculator.

For example, let’s consider the investment return assumption. The conventional wisdom is that future investment returns will relate in some way to historical investment return. What happened in the past is what you should expect in the future.

There are variations on this theme, but the differences are less significant than the similarities. Monte Carlo calculators randomize the returns producing confidence intervals, other highly respected calculators “backcast” through actual market history, while simpler versions apply average historical returns as if volatility never existed.

Will the results produced by each variation be different? Yes, but surprisingly little. Depending on other assumptions used to complete the calculations, they all agree you can spend roughly 3-5% of assets annually during retirement. This result is remarkably close to the “4% Rule” or “Rule of 25” because it assumes the same variable for investment return.

The point is, none of these retirement calculators — from the simplest rules of thumb to the most sophisticated Monte Carlo algorithms — provide meaningfully different insight when they all use the assumption. Essentially, the answer is baked into the cake by the assumption.

If future investment returns resemble the past then they will all be roughly correct because they are based on the same assumption. If future investment returns are significantly different from the past then they will all be wrong regardless of how sophisticated they appear on the surface.

This is critical to understand. The assumptions are the key to accurately estimating how much you need for retirement — not the calculators. The reason is simple. The assumptions are what gets multiplied and compounded, thus determining your result.

Now that we know it’s all about the assumptions, let’s consider if it is even possible to make accurate assumptions so that you can produce an accurate estimate of your retirement needs. You might be surprised by the answer.

We will start with the longevity assumption:

How Long Will I Live?

Nobody knows when they will die.

The state-of-the-art answer in retirement planning is to use actuarial tables, but these are statistical averages that have no relevance to any one person’s date with destiny. Some planners adjust up or down based on health and family history, but it is all just a guess at something completely unknowable.

Using actuarial tables to estimate an individual life expectancy is an example of a fundamentally flawed assumption because the process is only accurate for large numbers. Actuarial tables were never intended as a tool to forecast individual outcomes because that is impossible to do. You are no more likely to die on your statistical average date than 10 years before or after. It’s a nonsensical approach – but it’s also the industry standard.

For example, multiple studies show a healthy couple at 60 has a very high chance of at least one spouse surviving 10 years or more beyond the averages; yet, the typical model doesn’t budget for this outcome. That’s very dangerous.

On top of that, longevity has been increasing close to 100 days per year for the past 100 years adding 30 years to life expectancy in the last century. By the time you become part of the statistical average, the tables will indicate a considerably longer life span when compared to today’s estimate. It is a moving target that is regularly growing.

The point is that today’s average life expectancy tables cannot be used to forecast individual life expectancies in the future. There is zero scientific validity to the approach.

The truth is you may as well just take a guess on your death date because that is all anybody else can do. Nobody knows. Nobody ever will.

What that means is the first assumption — longevity — cannot possibly be estimated with accuracy. The conservative solution is to estimate on the high side because the risk of underestimating is too large to accept.

How Much Will I Spend?

The conventional wisdom is to use 80-85% of pre-retirement income as a rule-of-thumb for retirement spending, but is this assumption accurate?

Like all things in retirement planning, it is subject to debate.

The logic seems obvious. You will no longer be commuting and you won’t have to spend money on professional clothes. More importantly, you won’t be funding your retirement savings plan so that source of cash outflow will vanish.

However, you are just as likely to increase lifestyle spending in the early years of your retirement while you have the health and vitality to enjoy an active lifestyle. Motorhomes, increased travel costs, recreation, golf club memberships, and other “necessities” can add up. These are expenses you didn’t incur when your days were spent in the office.

On the other hand, competing studies demonstrate how spending declines with diminished health in your later years. This also makes sense because as you slow down your activity level will require less money to support it. Unfortunately, many of the studies proving this point used a fundamentally flawed research approach that did not adjust for inflation, thus causing confusion over nominal versus real spending patterns.

If all this contradictory research leaves you uncertain then you are not alone. The truth is each individual’s situation is unique and no generic assumption will be accurate — least of all a simple rule-of-thumb like 80% of pre-retirement income.

The best solution is to formulate your own budget based on your life plans and make your best guesstimate. If you plan on extensive travel and recreation you may require 120% of pre-retirement income. Alternatively, if your passion is romance novels and knitting you may get by with 70% of pre-retirement income.

The truth is no matter how carefully you budget you will likely be wrong. If you’re not sure about this then try to imagine guessing your expenses today from the perspective of 20 years ago. Now look forward and ask yourself if you can confidently foresee your medical needs, changes in Social Security or Medicare, where you will live, what health issues you will confront, and how much it will all cost?

It can’t be done accurately.

The best solution is to build your own budget based on your unique plan for retirement. It won’t be perfect, but there is no better alternative for answering this required assumption.

How Should I Estimate Inflation?

PhD economists can’t accurately forecast inflation for even one year into the future, so how are you supposed to forecast 20-30 years into the future? It’s total nonsense; yet, financial planners do it every day by applying a linear projection of the past.

The conventional wisdom is to assume 3% inflation based on recent history (1980’s to current). The problem is government debt, entitlement programs, bank bailouts, and QE2 have become substantial problems compared to the recent past and don’t bode well for future inflation. Nobody has a Crystal Ball, but logic indicates mindless extrapolation of the recent past may not be applicable to the future.

In addition, you don’t have to stretch much farther back in time to find a dramatic contradiction to the 3% assumption. Prices doubled in the 1970s cutting purchasing power in half. For a decade and a half inflation was a real problem in this country until Paul Volcker got things under control.

The key point is you cannot estimate inflation for 30 years into the future with any degree of accuracy or confidence. It’s impossible because so much will change between now and then, creating unforeseeable circumstances that will determine the result. Yet, retirement calculators require you to guess anyway.

This is incredibly important because small changes in your inflation assumption will produce dramatic changes in your retirement savings needs due to compounding. Depending on other assumptions, a 2% increase in inflation can easily double your retirement savings needs. In other words, one little error can make or break your financial security.

Simply stated, inflation is the single biggest threat to your retirement because it can’t be accurately estimated, you have no control over its occurrence, and the effect is compounded over time thus magnifying small errors into big problems.

Be wary of the conventional 3% assumption because, if it proves optimistic, the impact on your financial security in retirement can be dramatic.

How Much Will My Investments Return?

Another assumption that’s critically important to your retirement security is your return on investment because it also multiplies through compounding over many years. As discussed earlier, the conventional wisdom assumes future returns will be similar to the past.

The problem with this assumption is your retirement security is dependent on what happens during the next 15-20 years — not the last 100. Long-term analysis can be very risky for retirees because it hides 15 year periods of flat or negative returns.

Breaking even for 15 years will devastate a retiree who spends 3% per year to support current lifestyle. It results in a 45% drawdown in portfolio assets (15*3%) even though the underlying investments actually broke even. Few retirees can recover from such a devastating outcome; yet, flat investment periods like this exist in long-term data and must be planned for.

Rather than rely on long-term historical data, a more reliable alternative is to estimate future returns based on current valuations as illustrated through research by John Hussman, Ed Easterling of Crestmont Research and many others. (A complete explanation of this research is beyond the scope of this already too-long article. Please see their web sites for more information).

The point is, expectancy models based on valuation provide a superior solution to estimating future investment returns when compared to the more common historical return assumption. Valuation-based expectancy models are statistically valid in timeframes of 7-15 years, which is about all retirees can afford to endure given their need to spend from principal.

In Summary: Six Rules For Using Retirement Calculators

The lessons are clear. The apparently simple process of calculating how much money you need to retire is a fa?ade masking a much more complicated reality. While the math is simple, the assumptions behind the math are far more difficult than they first appear.

In addition, we’ve also learned how the conventional wisdom for choosing values for the required assumptions has serious shortcomings.

So what’s a future retiree supposed to do? After all, you need to have some benchmark for retirement savings. An inaccurate goal is better than no goal at all.

Below are 6 rules for getting the most value of retirement calculators and not being deceived:

The Map Is Not The Territory: Never delude yourself into believing your retirement estimate is accurate. It is simply a calculated projection of the assumptions used. If any assumptions are incorrect the estimate will be similarly wrong.

Walk-forward Process: Don’t perform the retirement savings goal exercise once, put it on a shelf and forget it. Instead, check back every few years and see what assumptions proved valid and which ones did not. Adjust the assumptions, recalculate, and shift your plans accordingly. Rinse and repeat every few years. This way you will hit your retirement target like a rocket ship that constantly course corrects toward its target.

Errors Multiply: Small errors in estimates compound into large errors in results. Retirement savings are built and spent over multiple decades. A 2% error in inflation or investment return that is manageable over 5-10 years is a complete disaster when compounded over 30-40 years. Small details make big differences so pay close attention to the details.

In short, retirement calculators should not be used as commonly practiced. You should never take a guess at the required assumptions, create a fictitious number, and plan your financial future based on it. That is a dangerous mistake even though it’s exactly what most people do.

After years of working with clients as a retirement planning coach, certain techniques have emerged that are extremely valuable in providing viable workaround solutions to the impossible-to-make assumptions. You can plan your finances into the future with confidence and security when retirement calculators are used as follows:

Scenario Analysis: Use retirement calculators to test various retirement scenarios. For example, should you try to save your way to retirement with a traditional portfolio or pursue income-producing real estate as an alternative? Test both scenarios and see what the numbers indicate. How would a part-time hobby-business affect your retirement savings needs? What happens if you work 7 more years or convert your career into consulting for a phased retirement? Retirement calculators are fantastic tools for comparing the impact of various retirement planning scenarios. As you get creative applying various scenarios it usually becomes readily apparent what will work for your situation.

Teach Principles: Retirement calculators are invaluable for teaching essential retirement planning principles. Users quickly grasp how real return net of inflation is the only number that matters after just a few quick scenario tests. They also see the importance of time in compounding their way to wealth versus trying to save their way to wealth. They understand how much they must save to support $1,000 per month in spending. Without a calculator these concepts are difficult to grasp, but with a calculator they become obvious for even a layman. Each lesson learned will affect how you plan your retirement.

Confidence Interval: Since you can’t possibly estimate all the assumptions with accuracy, the next best thing is to use a range of plausible assumptions. Simulate one extreme by using all pessimistic assumptions like high inflation, low investment returns, and a very long life with prolonged medical expenses (just don’t have any razor blades nearby when you see the result). Then simulate the optimistic extreme with high investment returns, low inflation and a prompt, peaceful death without medical complications. You will be amazed. The pessimistic scenario can easily require 2-4 times the nest egg of the optimistic scenario. This can be a very instructive exercise for understanding the range of possibilities so you can plan accordingly.

In other words, use retirement calculators to plan, test, and hypothesize your retirement future. They are extremely useful when properly applied with a clear understanding of the inherent limitations.

It may seem like the task is impossible given the magnitude of the potential error factor, but with enough practice in scenario analysis you will find acceptable workarounds and solutions.

I provide a free retirement calculator designed just for this purpose here.

Also, you should avoid retirement calculators that limit your flexibility to change assumptions. The most obvious example of that is any calculator that has a built-in investment return function based on historical market returns.

In summary, the key to success with retirement calculators is to understand the inherent limitations and work around them. Never believe in the “magic number” myth. Sure, it’s a lot easier to use retirement calculators the conventional way, but with a goal this important it is worth the extra effort to do it right.