Reveals The Dangerous Assumptions Hiding Behind Your Retirement Estimate And Provides 5 Simple Steps To Solve The Problem
- Uncovers the most common retirement calculator mistakes so you don't foolishly step in the same potholes.
- Shows which assumptions are the most important so you know what to focus on.
- Explains the five rules you must follow for success when using retirement calculators.
Sure, retirement calculators are easy to use.
You input a few assumptions about the future and – presto – the computer instantly provides a number telling you how much you need to retire.
It even appears scientific and mathematically precise.
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 outputs based on assumptions that have almost no chance of being accurate.
They mistake the retirement road map for the territory. They’re misled by the scientific façade 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 you can see how to use this valuable tool correctly.
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How Retirement Calculators Work
Sooner or later, everyone confronts the question, “How much money do I need to retire?”
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 computerized algorithm that projects your future investment growth and expenses based on a required set of input assumptions.
It’s just simple algebra.
In other words, all retirement calculators use the same base assumptions to work their magic:
- Retirement age
- Life expectancy
- 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’re all calculating the same thing in roughly the same way using roughly the same input. That 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 the best. Heated discussion in forums have erupted over this issue.
Unfortunately, these discussions miss the point because the critical factor to the accuracy of your retirement estimate isn't 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. Simpler versions apply average historical returns as if volatility never existed.
Will the results produced by each variation be different? Yes, but surprisingly, not by much. 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. (See “Are Safe Withdrawal Rates Really Safe?” for an in depth discussion.)
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 similar assumptions.
Essentially, the answer is baked into the cake by the assumptions chosen. It’s just math.
If future investment returns resemble the past, then they’ll all be roughly correct because they’re based on the same assumptions. If future investment returns are significantly different from the past, then they’ll 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 get multiplied and compounded, thus determining your result. Seems obvious once it's explained that way, right?
Now that we know it’s all about the assumptions, let’s consider if it’s even remotely possible to make accurate assumptions so you can produce a close estimate of your retirement needs.
You might be surprised by the answer.
We’ll start with the longevity assumption…
How Long Will I Live?
Nobody knows when they’ll die.
The state of the art answer in retirement planning is to use actuarial tables, but these are statistical averages which 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’s 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. The process is only accurate for large numbers.
Actuarial tables were never intended as a tool to forecast individual outcomes because that’s impossible to do. You’re 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.
(Editors Note – Yes, I understand much of this increase comes from reduction in infant mortality, but other studies show increasing lifespans as well, particularly for those who receive proper health care.)
By the time you become part of the statistical average, the tables will likely indicate a considerably longer lifespan when compared to today’s estimate. It’s a moving target that’s regularly growing.
The point is today’s average life expectancy tables can’t be used to forecast individual life expectancies in the future. There’s zero scientific validity to the approach, yet it’s industry standard practice.
The truth is you may as well just take a guess on your death date because that’s all anybody else can do. Nobody knows. Nobody ever will… until it's too late.
What that means is the first assumption – longevity – can’t possibly be estimated with any 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?
This second assumption is usually applied using the conventional wisdom that 80-85% of pre-retirement income should be sufficient for post-retirement spending, but is this assumption accurate?
Like all things in retirement planning, it’s subject to debate.
The logic seems obvious. You’ll 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’re 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.
RV’s, 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 studies proving this point used a fundamentally flawed research approach that didn’t adjust for inflation, causing confusion over nominal versus real spending patterns.
If all this contradictory research leaves you uncertain, you’re 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 spending 80% of your 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’ll 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’ll live, what health issues you’ll confront, and how much it’ll all cost.
It can’t be done accurately.
The best solution is to build your own budget based on your unique plan for retirement, as we teach in our systematic wealth planning course. It won’t be perfect, but there’s no better alternative for answering this required assumption.
How Should I Estimate Inflation?
The third assumption – inflation – is total nonsense. Yet, financial planners guess at it every day by applying a linear projection of the past.
Making this assumption is absurd. Even PhD economists can’t accurately calculate inflation for one year into the future. Yet somehow, you’re supposed to forecast inflation 20-30 years into the future. It makes no sense.
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, 3, and so on have all 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.
Until Paul Volcker got things under control, inflation was a real problem in this country for a decade and a half.
The key point is you can’t 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 the compounding effect.
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, turning 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.
Related: 5 Financial Planning Mistakes That Cost You Big-Time (and what to do instead!) Explained in 5 Free Video Lessons
How Much Will My Investments Return?
This fourth assumption is critically important to your retirement security 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. It also doesn't address the important impact that sequencing of returns has on running out of money.
For example, breaking even for 15 years will devastate a retiree who spends 4% per year to support their current lifestyle. It results in a 60% draw-down in portfolio assets (15*4%) even though the underlying investments actually broke even.
Few retirees can recover from such a devastating outcome, but flat investment periods like this exist in long-term data and must be planned for (just ask anyone who retired in 2000).
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, Campbell and Shiller, and many others.
(A complete explanation of this research is beyond the scope of this already too-long article. Please see their websites for more information or examine my course, Expectancy Investing, for a complete solution.)
The point is expectancy models based on valuation provide a superior solution for estimating future investment returns when compared to the more common historical return assumption.
Valuation based expectancy models are statistically valid in time frames of 7-15 years, which is about all retirees can afford to endure given their need to spend from principal.
In Summary – 5 Rules For Using Retirement Calculators
The lessons are clear. The apparently simple process of calculating how much money you need to retire is a scientific façade masking a much more complicated reality.
While the math is simple, the assumptions behind the math are far more difficult than they appear on the surface.
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 5 rules for getting the most value of retirement calculators and not being deceived.
- The Map Isn't The Territory: Never delude yourself into believing your retirement estimate is accurate. It’s 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 didn’t. Adjust the assumptions, recalculate, and shift your plans accordingly. Rinse and repeat every few years. This way you’ll 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’s 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 shouldn't 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’s 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 by applying the following principles…
- 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.
In other words, use retirement calculators to plan, test, and hypothesize your retirement future. They’re 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’ll 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.
If you want a more accurate calculation, our wealth planning course goes in-depth on scenario analysis and provides you with all the steps you need to engineer a secure retirement.
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’s worth the extra effort to do it right.
Your financial future depends on it.
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Like everyone else there is double accounting for inflation and ignoring dividends in this article. There is a line about suppose the market is break even for 15 years, this leads to a drop of 60% in your retirement account. No it doesn’t. First off you are withdrawing 4% per year which is a lower withdrawl each year so this leads to a 46% reduction instead of 60 percent. Secondly, if you take a reasonable dividend of 2% (even assuming the dividend is reduced to maintain 2% of existing share valve) your total assets fall 26% over this period not 60 percent.
A 26% drop is pretty stiff indeed and will lead to problems but not accurately looking at the analysis is more likely to keep suckers working years after they could have retired.
Fact of the matter is most people don’t have enough to retire and need to adjust their life style after stopping work. If you can meet the 4% rule you don’t just have a safe retirement, you have an ironclad retirement.
Asparagus, you comment saddened me. It’s a bummer to see how after all these years of educating there is still gross misinformation getting passed off as fact. Given your dangerous level of overconfidence in your analysis using terms like an “ironclad retirement”, I think it merits taking this comment apart line by line.
“Like everyone else there is double accounting for inflation and ignoring dividends in this article.”
I never ignore inflation or dividends. I don’t know who “everyone else” is that you are referring to, but I assure you they are absolutely not ignored here.
” There is a line about suppose the market is break even for 15 years, this leads to a drop of 60% in your retirement account. No it doesn’t. First off you are withdrawing 4% per year which is a lower withdrawl each year so this leads to a 46% reduction instead of 60 percent.”
Ummm, you are wrong. Totally wrong.The 4% rule is based on your portfolio value on the first year of retirement (not 4% of each year’s beginning value), adjusted for inflation as you criticized above. So the 60% rough calculation was actually low to keep the math simple since inflation adjustments will always add to that number, but will vary based on period. In addition, that calculation doesn’t adjust for volatility effect causing higher percentage withdrawals during drawdown phases, again, making the calculation provided in the article conservative.
” Secondly, if you take a reasonable dividend of 2% (even assuming the dividend is reduced to maintain 2% of existing share valve) your total assets fall 26% over this period not 60 percent.”
You are wrong again. The breakeven performance discussed above is a total return equation, inclusive of dividends and inflation per your first inaccurate criticism. Your comment is indicative of a very common mistake floating through certain circles that you can pursue a dividend income strategy to offset your spending and that somehow magically solves the sequence of returns risk and withdrawal drawdown problems. That’s incorrect because the only return that matters is total return, on a compound (not average) basis, adjusted for inflation. When you approach the analysis by including dividends into total return, instead of excluding them, as done above, you’ll come to very different conclusions (that are more accurate).
“A 26% drop is pretty stiff indeed and will lead to problems but not accurately looking at the analysis is more likely to keep suckers working years after they could have retired.”
Your derogatory choice of the term “suckers” is unnecessary. It implies that you’re holding yourself above the masses as more knowledgeable, or intelligent. It adds no value, but only detracts from your message, which as shown above, is incorrect anyway. With that said, I will agree with you that the “one more year” syndrome is a problem for many people. But it is not caused by what you are stating, but instead is more generally related to the uncertainty inherent in the estimating an unknowable future that requires you to convert a volatile portfolio into a stable income stream you’ll never outlive. Smart people (not suckers) experience an appropriate level of concern in the face of that uncertainty and tend to pad their numbers to deal with it.
“Fact of the matter is most people don’t have enough to retire and need to adjust their life style after stopping work. If you can meet the 4% rule you don’t just have a safe retirement, you have an ironclad retirement.”
You are expressing your personal viewpoint as a general fact. Not a good idea. The numbers support your first assertion that most people don’t have enough to retire using conventional analysis, but that doesn’t mean they have to adjust their lifestyle. That is one viable alternative, but they could also choose to work longer instead. Or they could pursue supplemental sources of income like an encore career or part time work. Finally, your statement that meeting the 4% rule is an “ironclad” retirement is completely unsupportable based on quality research. The 4% rule fails with shocking regularity when tested on international data. Additionally, correlation based models that that extract the primary components driving the variation in safe withdrawal rate across time periods (interest rates, market valuation, and inflation) cast massive doubt on the 4% rule being anywhere close to viable at the time you wrote this comment (July 2019). So to claim it as “ironclad” is grossly inaccurate.
I hope that helps clear up some of the inaccuracies and misinformation that you are operating under.
I enjoyed your article. Did make me stop and think about how important those assumptions were and how little thought I had given them. I was working with your calculator playing some ‘What if?’ games and had a couple of questions concerning the tool. Hopefully you can help me understand better how it works.
1. The input field “Current total retirement savings ($):” Not sure what to enter there when I have pre-tax retirement savings (like my 401k, traditional IRA) and after tax savings like Roth IRA’s that I’ll never pay taxes on and some after tax savings like a mutual fund where I may have capital gain taxes. I used an example of where I was 61 at year end and I would retire at 62. The first line of the table showed my interest earnings and the year end balance was the total of the year begin balance and the interest. Is it assuming that I paid taxes on that interest from some other source or that the interest is not taxable until I spend it? Maybe what I’m asking is how are taxes addressed on my existing savings?
2. I had to enter Social Security and Pension as an after tax number. This caught me off guard. Maybe this ties back to my first question of how the tool addresses the impact of taxes.
3. I think I figured out inflation was being handled by adjusting the amount that I wanted to have each year for spending. Is that correct?
4. Would I include my HSA? I fund mine with no intent of using it for current health expense, but rather to use it to pay for Medicare premiums. Guess it’s like an traditional IRA?
Can you help me understand the Net Present Value column. Was unable to figure that one out.
I appreciate these articles and the willingness of folks like yourself to make them available freely.
Thanks in advance,
Dave, I would love to be able to answer all of your questions, but I have close to 10,000 people per day using these calculators. I’m paying for the privilege (in terms of hosting, maintenance, and programming) just to provide them. If I tried to personally help even 1% of these calculator users I’d never sleep, never get any work done, and end up divorced. The solution is for you to spend some time with the spreadsheet output. It’s provided so that all output is disclosed. Since nothing is hidden it means you can answer all of your questions with a reasonable amount of digging. Hope that helps!