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.
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.
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.