December 21, 2017
Retirement calculators can be a valuable first step in calculating retirement needs.
By using one of these online tools, you start thinking about your future. You get organized and become aware about what you have, what you need in retirement and how you can get there.
By entering in some basic information the calculator provides an estimate of your retirement outlook, such as: how many years your money will last, how much you will have and how much you need at retirement.
You may be saying, "Liz, retirement calculators sound peachy. What's the problem?" Well, anonymous and fictional reader, I'm glad you asked. As easy and straightforward as retirement calculators appear, they have several limitations that could have a major impact on your retirement planning.
Why retirement calculators are wrong:
- Sequence of returns: Calculators use a flat rate of return, typically based on a historical average or a rate the user provides. However you are almost guaranteed that your portfolio will suffer a down market at some point, and the retirement calculator doesn't take variances in return into account. A bear market can cause losses of 40-50%, or more. The problem is in the timing of the negative returns. This is referred to as sequence of returns. During your retirement years, if a high proportion of negative returns occur in the beginning years of your retirement, it will have a lasting negative effect and reduce the amount of income you can withdraw over your lifetime. Conversely, if there's a bear market that reduces your portfolio by 25% in your early years of savings, you have some time to make it up.
- Not all calculators are created equal: If you Google "retirement calculator" you are provided with hundreds of results. As you probably know in your own research, some calculators are better than others. In a recent study, researchers who tested 36 online retirement tools gave only 11 a passing grade. Most failed because they were too simplistic. The more input the calculator analyzes, and the more freedom the tool provides to play with the numbers and compare multiple scenarios, the better. A few calculators I like are: NewRetirement, Vanguard, Bankrate and Fidelity.
- All the information is wrong: It's true. The calculations are dependent on pure assumptions. Who knows how long you'll live, or how much you'll spend in retirement each year? The calculator estimates the inflation and returns, but it's just that: an estimate. And even the smallest error on a rate of return or interest rate can make a huge different in the calculations. Since the inputs are guaranteed to be inaccurate, it's safe to say that the results will be too. Again, that doesn't mean retirement calculators are not valuable. But how you use (or misuse) the results is the key. The results should be seen as an estimate and starting point that shows if you're on track or not. If your retirement calculator says that you can't retire for 112 years, then you know it's time to make some changes. If it tells you that you'll die with $170 million in the bank, you're probably on a good path (but continue to monitor).
How to make your retirement calculator work for you:
- Use it as a starting point to get a picture of how much you have and how much you need for retirement.
- Input your information as accurately as possible, but remember that things change and we can't predict the future. To get a better idea of your retirement prognosis, play with the inputs to get several different scenarios. Try a later retirement age, longer life span, lower / higher returns, less / more income at retirement and various inflation rates. Then use these scenarios to get a 360 degree view of what retirement could look like for you.
- Don't use the calculator once and rely on that number. Your life, the market and the world will continue to change, so repeat this exercise once a year, or with any major changes.
- When in doubt, remember the 4% rule of retirement. The 4% stems from a 1994 study by financial planner William Bengen, who was looking for a way to help clients figure out how much they could withdraw from their retirement each year without running out of money. Bengen found that 4% was the highest withdrawal rate retirees could use if they wanted their money to last at least 30 years, as the withdraw was primarily interest and dividends. Recent years has caused some experts to question this number, believing this number should be closer to 3%, so plan for somewhere between 3-4% withdraw.
