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How online retirement calculators can mislead you

Photo of Lars Kroijer.

This article about online retirement calculators is by former hedge fund manager Lars Kroijer, a regular contributor to Monevator. He is also the author of Investing Demystified.

The Internet has revolutionized access to information, as we have discussed many times on Monevator. Investors can now find a plethora of tools on the Web to help us better manage our finances and lower our costs.

But are you getting the whole story from these free resources?

Retirement calculators, for example, apparently serve a very useful function. You simply feed a few data points into the calculator and voila – the computer tells you whether or not you’ll have enough money for a happy retirement in your old age.

Job done? Sadly, it’s not quite so simple.

Calculated odds

Take a look at the CNN Retirement Calculator, for instance. This tool has all the standard options to change the inputs, but for the purposes of this article I stuck with its default assumptions:

  • I am 35 years old (I wish!)
  • I will retire at 67
  • I have $100,000 saved up
  • I earn $55,000 a year…
  • …of which I’ll save 15%

Reading through the calculator’s methodology footnotes, we learn it assumes your income will grow 1.5% above inflation. Your investments (both current and future) are projected to return 6% per year, presumably before inflation of 2.3% (so a 3.7% real return). We aren’t told if that is a compounding return or annual average.

To calculate your future spending needs, CNN works out what it costs at retirement to buy an annuity that gets you 85% of your pre-retirement income. While CNN uses US dollars (USD), the logic would be the same in other currencies.

Choosing to input all this data in real terms amounts (that is, after-inflation) and with the assumptions listed above, the CNN calculator tells us we will have enough money for retirement.

Phew. It seems we’ll have $883,000 in today’s money, and that we actually only need $804,000.

That’s nearly $80,000 spare to put towards a big retirement bash!

Risk and retirement

Now before I start saying what is wrong with this logic it is important to mention that the CNN tool does do a lot of important and useful things for you.

It reminds you of the importance of saving for your retirement. It gives you an idea of orders of magnitude. It has figured out the math of long term savings and the eventual cost of annuities. And it’s done all this without charging you a penny.

However in my view the calculator also gives you a false sense of security that is important to understand.

In particular, the return assumption in the model is 3.7% after inflation. The yield after inflation of US/UK 30-year government bonds is currently around 0.8%. Since these government bonds are perhaps the most ‘riskless’ investments, we’ll obviously need to take some risk to get up to an annual return of 3.7% after inflation.

And therein lies the problem. These kinds of calculators lead you to believe that if you do what is said in their assumptions, then you’ll have enough money. End of story.

But that is only the half of it.

You see, if you need to take risk to earn that 3.7% post-inflation annual return, then there is obviously a risk that things don’t go according to plan and that you fall short of reaching your retirement goal.

And it’s critical that you know this before you blindly assume that your savings will be enough.

Risk and returns

How much risk do you need to take to get a 3.7% real return?

If we assume that we can get 0.8% from riskless bonds and that equities deliver about 4.5% a year in real terms (a little lower than what they have in the past) we can reasonably expect a 3.7% annual return from a portfolio that comprises roughly 20% long term government bonds and 80% equities.

But a portfolio that is 20/80 bonds/equities will have a broad range of potential outcomes – particularly over a whole working life.

How broad is the range, and in how many cases does it leave us with insufficient money?

It all depends on your assumptions of risk with respect to equity markets – or whatever other types of risk investment you make – and on whether you accept the calculator’s 4.5% return expectation.

The point is the certainty suggested by the calculator is really just an educated guess as to how on average things will turn out.

Calculators with caveats

Instead of saying ‘you will have enough’, or ‘you need to contribute more’, I would prefer such calculators to say ‘given these [stated] assumptions on risk of the returns, we think there is an X% chance that you have enough’.

This is important, because that is how it works in the real world. There are very few sure things in investing. If you’re saving for retirement, it’s best you know that from the start.

Instead of the false sense of security that the CNN calculator gives you, it would be better for you to know and understand the probability of falling short. Then you can think about how happy you are with that probability.

Would you be comfortable if I told you there was a 20% risk of falling short? What about a 10% chance? 5%?

It all depends on your circumstances and your feelings towards risk.

Your attitude towards risk – as reflected in different inputs you would then feed into your projections, and the outputs you’d be given – will demonstrably alter what spending power you can hope to achieve in retirement.

A more transparent exploration of risks and outcomes would also enable you to see how by changing your investment allocations or pension contributions today, you might influence your financial future.

Build your own retirement spreadsheet

Below you’ll find a video that further addresses the issues around the CNN retirement calculator:

I built a financial spreadsheet to address the issues in the CNN and other calculators, in order to enable investors to understand these issues and play around with the impact of different assumptions.

You can read my article explaining why and how you should build your own spreadsheet. Then check out my ongoing How To series for more on YouTube.

As with my previous Monevator pieces I’d really like to hear your views.

Please comment below on what you’d like to see added to my model or anything that you believe I could explain better. I’d like the model to be as accessible and useful as possible, and your feedback is greatly appreciated.

Check out the new edition of Lars’ book, Investing Demystified.


Weekend reading: Stuff to read while we’re elsewhere

Weekend reading: Stuff to read while we’re elsewhere post image

What caught my eye this week.

Apologies to the many thousands dozens of readers who checked in during the week and found no new Monevator posts – for the second time in a month!

Pretty shocking, considering it’s probably only the third or fourth time this has happened in the past five years.

Away from the site I’ve got quite a lot going on at the moment – and their different ways all the other core Monevator contributors have had busy summers, too.

Hopefully we’ll get back into the swing of things in a few weeks. Until then, you’ll find another monster list of links below.

(One thing I never stop doing is reading!)

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Weekend reading: If the market is getting dumber, active managers must be morons* post image

What caught my eye this week.

How is it September already? Once again spring teased us with a heatwave, summer soaked us, and autumn is sneaking up with an existential crisis.

Some things never change, however, such as passive investing guru Larry Swedroe’s ability to take apart criticism of indexing strategies with the precision of the EU’s Michael Barnier taking apart the delusional New Victorians we’ve sent to Brussels to peddle Brexit for us.

But we did that last week, so instead let’s enjoy a quote from Swedroe on the idea (pretty much fabricated in a fund management marketing department brainstorm, as best I can tell) that markets are becoming inefficient as a result of passive investing:

50 years ago, there was a small fraction of the number of mutual funds we have today, and the hedge fund industry was in its infancy. On top of that, individuals dominated the market, because the majority of stocks were held directly by investors in brokerage accounts.

The research shows that retail money is “dumb” – active managers exploit its pricing errors. But even back then, the evidence was that on a risk-adjusted basis, in aggregate, mutual funds underperformed – though not anywhere close to as poorly as they are doing today.

For example, about 20 years ago, roughly 20% of active managers were generating statistically significant alpha.

As noted above, the figure today is just 2%, with no evidence the trend is reversing.

Just 2%! Where are the active managers skipping around picking up the golden apples that passive investors are scattering across the ground?

Nowhere, that’s where. Active investing must always be a zero sum game, but if the market is really getting stupid then more than 2% should be profiting from it. They’re not.

I love stock picking, but I wouldn’t pay anyone to do it for me. If I am going to pay over the odds for something I can do for myself, I want to know I’ll get superior results.

Sushi chef? Foot masseuse? Belly dancer? I’ll happily shower money on them.

Almost-certain market-lagging fund manager? Not so much.

*To be clear, active managers are not morons. They’re invariably extremely clever, and I’ve enjoyed the company of every manager I’ve met. The answer to the riddle is rather that the market has NOT got any dumber due to passive money. It may never.

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MiFID II and you

The MiFID II regulations reportedly run to over a million paragraphs of rules.

A few readers have asked me why they’ve received emails from their brokers requesting they confirm their nationality and national insurance number.

Are these emails legitimate? If so, why now?

With everyone on heightened alert due to tensions on the Korean peninsula and the trauma of Game of Thrones, it’s natural to be suspicious.

I can’t know whether any particular email you’ve been sent is a phishing attempt. Be alert to identity theft and other scams. Take sensible precautions.

I can confirm though that stock brokers and platforms are indeed requesting such information. Here’s the gist from an email I got from Hargreaves Lansdown:

New legislation (The Markets in Financial Instruments Directive 2 (MiFID II)) requires us to confirm your nationality and National Client Identifier (NCI) by 3 January 2018.

Your NCI will depend on your nationality but in most cases it will be something you’ve already been issued with. For example, for UK nationals it’s your National Insurance Number.

If you do not provide this information, you will be unable to trade shares, ETFs, investment trusts, bonds and a number of other stock market listed securities from 3 January 2018.

The request is legitimate. It is not just an attempt to grab excessive data for the company’s own purposes. (We’ve seen that in the past under the guise of what’s called Know Your Customer).

What then is MiFID II, and why does it mean your broker needs to know your nationality and NCI?


You will not be surprised to hear that MiFID II is the sequel to MiFID – only with bigger and badder special effects.

The original MiFID was a 2004 European Law that harmonised regulation for investment services across the European Economic Area. It aimed to increase competition and consumer protection.

MiFID effectively came into force in November 2007 – just on the eve of the financial crisis – which probably tells you all you need to know about why we’re getting a follow-up!

MiFID II – and an associated piece of regulation called MiFIR1 are again pitched as increasing investor protection. There is also much talk of reducing the risks of disorderly markets and curbing systemic risk. The regulations aim to improve transparency in how markets operate. In my (skim) reading the competition focus seems to have been downplayed, with an emphasis instead on improving efficiency.

At the last count the MiFID II legislation ran to 1.4 million paragraphs of rules!

Even the people tasked with compliance surely can’t have read more than a fraction of them. Perhaps big companies will cope through divide and conquer, but it seems probable smaller companies will struggle.

Perhaps that’s one reason why competition seems to have taken a back seat with MiFID II? The cost of financial firms complying with the new rules has been estimated at over £700m across the sector. Bigger firms have more money to scale up their technology and other systems. Little companies may bow out of some markets, which could in theory reduce competition.

You can read a lot more on MiFID II via the FCA website if you’re so inclined.

What does MiFID II mean for everyday investors?

There are many people infinitely more qualified than me to talk about MiFID II; I just wanted to confirm that the broker requests are real and that this legislation is coming.

What’s more, there’s a lot of controversy about the new rules. Some say this or that aspect will be good for consumers. Others say bad – especially in the long-term, or when you take into account unintended consequences. I’d rather adjudicate an arm wrestle between Trump and Putin than take sides at this point.

However here are a few quick pointers as to where MiFID II might affect us. You can dig in further if you like, and share any thoughts in the comments below.

Greater market transparency – Trading venues will be required to store and crosscheck vast amounts of data to comply with MiFID II and improve transparency. One aim of regulators, for example, is to prevent the sort of uncertainty about who is trading with who that froze markets in the credit crunch of 2007. This will be why brokers are asking for your information if you want to trade shares directly in the market. (In contrast, with at least some brokers you are not being asked to give nationality information if you only invest through collective funds). Companies, charities and other non-persons will need what is known as a Legal Entity Identifier to trade. Your broker will have one, and I presume it needs to know exactly who you are so it can then trade transparently on your behalf.

Much more detailed cost disclosures – Firms will be required to explain to clients (i.e. us) all “the appropriate details of all costs and charges within good time.” This is potentially a bit of a game changer. It is something that lobbyists such as the Transparency Task Force have been campaigning for. In theory investors in active funds will become more aware of all the costs they are paying for; this could cause more of them to go passive, as they almost certainly should. (I say ‘in theory’ because there is a counter-argument that people will be overwhelmed, and that a genuine all-in-one total fee would be more useful. But obviously it’s less transparent.)

‘Unbundling’ the purchase of investment research – Talking of those hidden costs, this one has been discussed quite widely in the press. Currently most fund managers effectively pass the cost of research – even apparently ‘free’ research – on to clients, by delivering investor returns after such costs. Under MiFID II the cost of passing on the research bill will have to be revealed. Some outfits such as Vanguard and Woodford have already pledged to instead pay for research out of their own profit and loss account. In theory such a cost reduction would mean slightly higher returns for us investors. (Though again, cynics might wonder how not paying for current accounts has worked out in scandal-strewn High Street banking…) Robin Powell for instance at The Evidence-Based Investor has been quite vociferous about the need for transparency here. But others have argued retail investors could lose out, particularly when it comes to small cap shares. They say some fund firms may simply give up on these markets as less profitable. (For my part I am not sure where the line stops in what should need to be declared to clients – office furniture bills and coffee refills? What ultimately matters is actual net returns, however they are derived, not costs, to my mind. It’s just that higher costs usually correlate to lower returns, which is why people should index. And that shows up in returns, and is derived from common sense.)

Taped conversations with financial advisors – For a while it seemed advisors could be required to record all your conversations with them. Yes, even the ones you have face-to-face in their little office above McDonalds on the High Street. However the FCA is now guiding that MiFID II will only require advisors to record online and telephone communications. As I read it, the FCA is saying advisors must explicitly record trade and order information. In other words this isn’t about addressing PPP mis-selling type situations – it’s about the financial markets side of the regulation.

Tweaks to the need for ‘independence’ from advisorsReportedly:

The FCA confirms it will adopt the Mifid II standard for independence.

The FCA’s current standard, that independence requires a comprehensive and fair analysis of the relevant market and be unbiased and unrestricted, will be superseded by a “sufficiently diverse” look at the market, with some retail investment products excluded.

However, the FCA says there is unlikely to be any widespread, significant implications from the change, though some IFAs may narrow the scope of their advice while remaining independent.

Mifid II bans inducements for independent advice, and the FCA has confirmed it will extend this to restricted advice to retail clients. It stopped short of extending this to professional clients however.

Best execution for clients – Under existing rules, firms are already required to have a written policy that details the factors they consider when executing orders for clients (such as price, volume, speed, and chances of execution). MiFID II goes further, requiring more detail upfront in terms of their execution practices, and evidence that they are seeking the best execution (e.g. the lowest purchase price) for their clients. You would expect this to be good for retail investors (who wants ‘second-best execution’, eh?) but it’s a murky and technical area. Think high-speedy trading, algorithms, dark pools, and other such exotica. What if liquidity is reduced – e.g. there are fewer venues to trade in, or lower volumes – because of the costs of complying with MiFID II? I see a risk, particularly when it comes to small cap shares. Some of the firms have claimed the difficulty of so-called ‘cost transaction analysis’ makes meeting the legislation difficult if not impossible. Others argue it just needs superior technology. (Let’s just hope we don’t pay for the upgrades…)

Good, but probably with catches

This article was only supposed to be a short article. As usual we’ve waffled off into the weeds.

Just be glad I spared you almost 1.4 million paragraphs, compared to MiFID II!

In practice there will probably be winners and losers from the new rules. Certainly among the financial services industry, where many seem to be struggling to meet the January 2018 deadline, but probably also with aspects of retail investing.

For instance, one column in the FT [Search result] on the difficulties of implementing MiFID concluded that:

Overall, the drive to achieve the best price for the customer and to make it clear to customers exactly what they are paying for can only be a good thing for end investors. Better late than never.

Yet that article prompted a thoughtful sounding letter from the CFO of Fidessa, a company that specialises in providing exactly the sort of software needed to comply with MiFID II’s requirements.

You might think his response would be “hear hear!” but actually he wrote:

Best execution is even more troubling as, without a clear idea of the original trading objective (price, speed, avoiding market leakage), demonstrating that one route was better than another becomes tricky.

Furthermore, no two firms measure this construct the same way and so any comparisons between brokers are almost meaningless.

A better approach would have been to provide transparency through standardised, industry level measurement so that all participants could then be compared and contrasted in at least some rudimentary ways.

Given that the frictional costs of changing broker are relatively low why not then let market forces do the heavy lifting as the good performers will get more customers.

So I fear that all that Mifid II will really deliver will be Mifid III and IV and so on into a never-ending box set that we have all been forced to binge on for long enough.

What I do know is that costs – and indeed regulation – in financial services tends to be like playing with the plasticine hairdresser my sister had as a child. You squash down on one bit and something squirts out elsewhere.

That’s not to say MiFID II is a bad idea, or that it won’t be good for us consumers. But there will be unforeseen consequences.

But anyway, be sure to let your broker know those details by January!

Further reading:

There’s tons of stuff out there via Google and via my links in the article above. Here are some other ideas to get started if you want to know more.

  • The FCA has a ton of MiFID II material on its website.
  • The FT’s definitive list [Search result] of asset managers that will pay for research.
  • The Hargreaves Lansdown FAQ is pretty easy reading.
  • This FAQ from investment bank MNY Mellon is clear and detailed.
  • Law firm Linklaters has a page of links detailing the state of progress in transposing MiFID II into UK law. It might help you find an answer to a specific technical issue.
  1. Markets in Financial Instruments Regulation []