How online retirement calculators can mislead you

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%?

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.

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.

• 1 Factor September 21, 2017, 10:27 am

Typo alert – “The point is the certainly [sic] suggested by the calculator …..”

• 2 RetireJapan September 21, 2017, 11:21 am

It lost me when it wouldn’t let me set my savings rate over 25% 😉

• 3 JohnG September 21, 2017, 12:30 pm

One of the reasons why I’m not sure focusing on the % chance of having enough is that I think it is likely to encourage ineffective behaviour in various groups:
1/ If you’re a relatively limited earner who is starting late then the figures needed for an ‘ok’ retirement are already scary enough many try and ignore it. Point out that even heavy saving might not be enough and it could make it worse.
2/ People who are a bit paranoid about having enough can already save well beyond their likely need and hoard money. Pointing out that they have a 1% chance of coming up short, without managing to make it clear that it would only be slightly and that they have a 80% chance of having excess they don’t need could exacerbate this tendency.

I’m really not sure what the best answer is, or even if there is a good way to give people a simple to calculate answer without trading off shortcomings. A tool which wants a handful of inputs is unlikely to give the best answer for anyone, however if it can give an answer that is good enough to people who are unlikely to used more complex tools then I’m not sure perfection is the standard we should be expecting.

• 4 Jim Hughes September 21, 2017, 2:07 pm

The method of retirement planning I used was of absolutely no help to anyone so feel free to skip to the next comment.

I didn’t use propriety calculators or sweat over future outcomes that I decided I couldn’t predict or control. All planning options depend on your personality type to some extent and definitely on your income level. For example, at one extreme, having limited resources, minimal investment knowledge and being of a nervous disposition would justify looking for as much guidance and reassurance as possible.

My approach was based on being, hopefully, reasonably investment savvy and increasingly so as I learnt by trial and error.

I just saved and invested as much as possible in the stock market until I retired. The final portfolio value would be what it would be and we would have to live with the consequences. On retirement, I planned to live on the much quoted 4% of the value.

You might be thinking that my wife and I were probably earning a fortune so didn’t need to sweat the future. Not so, I was a middle of the road salaried professional and she a teacher. Comfortable for sure but not loaded. Our total pension income is a measly 5k a year.

In reality we now spend only about 50% of total income before tax. This low figure is due in part to my wife and I not being big spenders by nature. We are very aware of how privileged we are and use some of our excess to help others we know.

As I said at the beginning, this post is of no practical help to anyone.

• 5 The Investor September 21, 2017, 3:28 pm

@JohnG — Yes, personally I am inclined to agree. It’s certainly not a silver bullet solution. If you’re the one person in 1,000 who gets a particularly nasty rare illness, you really care about that illness! And if you ask people straight after seeing a documentary about the illness what they’d do to avoid it, I bet you’d get orders of magnitude more people saying “almost anything” then if it was just another question in a questionnaire with “1 in a 1000” written against it. My point is these things are very hard to quantify.

A doctor friend once told me most patients here any sort of percentage description of the odds of success with treatment as ’50/50′. (So you can say 70%, say, but they basically go away thinking 50/50).

That’s not to decry Lars’ point because (a) the calculators should show you all ways and (b) his bigger point is that creating a spreadsheet and understanding what is actually driving these outcomes is a far better route to knowledge. 🙂

@RetireJapan — Hah, that seems rather unambitious of CNN. 🙂

@Factor — Thanks! Fixed now.

@Jim — Well, I find it somewhat reassuring at least, as it closely approximates mine! Unlike my co-blogger, who very much has his ‘number’ he’s aiming for, I am just piling it all up. It works for me though because I am an investing mad nutcase. If all this was a necessary evil, I’d presumably want to minimize the, well, investment.

• 6 Steveark September 21, 2017, 4:33 pm

One thing the calculators do not estimate is the declining spending profile of retired people. From watching my own parents and other older friends I haven’t seen any retired people spend anywhere near 85% of their pre-retirement income. Also many of them continue to work part time often with their original employer on some kind of contract basis. And as they age their spending drops off even more because travel becomes more of a hassle and they drop some of their more active and expensive hobbies. Medical spending does increase but most of that is covered by government insurance. My parents net worth increased every year of their lives all the way up until they died at 89 even though they were in nursing homes the last few years. I’m early retired for two years now and am spending only 25 to 30% of my pre-retirement income and living pretty large.

• 7 Hariseldon September 21, 2017, 4:42 pm

A percentage outcome of success to a model implies a degree of accuracy that these types of calculations are totally unable to achieve. I’d suggest a traffic light result,
Red, a good result is unlikely on the inputs
Orange , it’ll probably be OK
Green, its looking OK.

I ran through a drawdown calculator recently, RetireEasy, it was free but starts to charge soon and so I thought I’d look at it again, you can fine tune the assumptions to a high degree of detail and I ran through the income that I need for a comfortable lifestyle and it said OK, I then increased the income desired box until I got to three times the original income and it still said ok but with minimal headroom, a modest adjustment to the assumed returns and the answers are a huge difference, no criticism of the calculator as such but all these models that cover compounding over 30 or 40 years are exponentially linked to the assumed growth, inflation rates.

If we take the input numbers that seem sensible today and cast our minds back 5,10,15 ,20 ,25 years then the assumptions we would have used then would have been wildly different and not reflected the actual outcome…..

This is the crux of the difficulty, no one knows what comes next, its unknowable.

It comes back to generic advice, keep your living expenses low, its less income to replace and an opportunity to save more. Save as much as you can, follow the general drift of advice on Monevator, diverse, low cost passive funds, save regularly, keep your nerve and over time it will probably pan out ok but there are no guarantees.

• 8 dearieme September 21, 2017, 6:40 pm

And for people on DB schemes:

(ii) Your scheme will fall into the Pension Protection Fund and you will lose all or most of your inflation-protection. Good luck with that.

(iii) Your scheme is so big that it would ruin the PPF and so you’ll depend on the whims of the politicians of the day.

• 9 Grislybear September 21, 2017, 6:46 pm

I looked at a lot of these calculators in the past and found them all to have problems and are only useful as a rough guide. The best system I have seen because its so simple is the Fidelity system. It simply states that at 30 have one years salary saved At 40 three times your salary saved. At 50 have 6 times your salary saved. At 60 have eight times your salary saved and retire when you have ten times your salary saved.

• 10 John B September 21, 2017, 9:03 pm

I wrote a sophisticated retirement calculator as a web application for my own benefit, couldn’t find a likely scenario for failure for myself and FIREd. I advertised it to friends and FIRE discussion boards, and no-one seemed to like it, it was either too complicated or didn’t match their circumstances. Often I suspect it was because when asked questions like specify different spending profiles to cover different periods of retirement, people just had no idea of the inputs, so had no confidence in the output.

One thing often omitted in probabilistic forecasts is the combinatorial factor of poor returns and poor health. A 5% chance of running out of money at 90 combined with a 5% chance of living beyond it is 1/400. You are much more likely to die earlier than you expect with more money than you expect

• 11 Naeclue September 21, 2017, 9:52 pm

Great article, these online tools give the impression that people will achieve average returns, whereas that is incredibly unlikely. Far more likely that any savings scenario would significantly over or undershoot the average.

Alas, estimating a probability of not achieving retirement goals is likely to be lost on 99% of the population. I also agree with the problem that Hariseldon has pointed out – estimates of the probability of failure are themselves likely to be highly imprecise. Many years before retirement it would be impossible to say with any certainty that there is a “20% risk of falling short”. You would need to provide an estimate of the error on the probability, which would then be lost on 99.9% of the population.

• 12 dearieme September 21, 2017, 10:39 pm

In principle you could avoid running out of money by flying off to Switzerland. Or, to save money even on that, by just turning your face to the wall. Or like a cat, crawl under a hedge.

But in practice most people would just demand that the taxpayer fund them.

• 13 Christof September 21, 2017, 11:03 pm

Sorry, a normal person would assume that a risk below 50% doesn’t affect him or her, as they will surely be one of the lucky ones, however as far as failing in retirement is concerned they want to be 99% sure, at least. Probabilities just escape most people.

• 14 Steve September 21, 2017, 11:13 pm

There are some good calculators out there. I like cfiresim to model the chances of retirement success. I also like the networthify retirement calculator to determine when you will have enough.

I don’t like any calculator that predicts your spending on some percentage of your current income. What matters is what you expect to spend in retirement which can be completely unrelated to your current income.

• 15 P September 22, 2017, 2:26 am

Another typo alert: the CNN caculator

• 16 Mr Optimistic September 22, 2017, 7:59 am

I suppose being 64 and having to think about how to best invest my existing pension savings I am at the wrong end of the spectrum for this article. However the general approach of all such calculators is to figure out how much of the savings burden to meet through saving, and how much heavy lifting by compounded gains will be needed to get to the goal. If I assume no growth beyond inflation and contribute a gross 20% of income, then 5 days working buys one day retired, or two if I reckon I will need 50% of my income in retirement.

Assuming an optimistic/pessimistic 30 years drinking wine on deck, and 30 years left at the coal face, the 30 years working buys 12 years retirement with these rock bottom assumptions. Assuming the state pays 50% of my retirement income stretches this to 24 years. Near enough. Now can start thinking as to how much uplift those compounded real gains may ( or may not) improve the outcome and mitigate the risk of the state staring me down!

The point being I think the savings level needs to be around the 20% mark as a sanity check. Below this and you are mortgaging your hopes of future world economic growth to an increasing degree.

• 17 The Rhino September 22, 2017, 11:30 am

@Steve – “I don’t like any calculator that predicts your spending on some percentage of your current income. What matters is what you expect to spend in retirement which can be completely unrelated to your current income.”

I agree, I’ve been harbouring a grudge against the following article since 2008 for exactly that reason;
http://monevator.com/try-saving-enough-to-replace-your-salary/

i.e. “The number on your pay check is therefore the number you need to beat.”

couldn’t agree less 😉

• 18 Hariseldon September 22, 2017, 11:50 am

There is a lot of luck as well in how things turn out, I experienced first hand the adverse sequence of returns as I retired in November 2007, a decline of nearly 50% by March 2009 was unwelcome….yet here I am in 2017 with 75% more capital ( after allowing for inflation).

I would like to take the credit for brilliant investment decisions but in truth there is a large element of luck (and quantitive easing helped as well). As much as you can model your investment plans, events occur and Plan A is ditched and you create Plan B and so on.

Simple advice, save as much as you can, as early as you can is what people need to understand, for some a calculator gives them a grasp of the numbers and for others a narrative, anecdotal examples of possible outcomes would help most.

• 19 dearieme September 22, 2017, 12:58 pm

@Mr Optimistic : “The point being I think the savings level needs to be around the 20% mark as a sanity check.”

My principal Final Salary scheme used to take about 20% by means of employer and employee contributions. And still it’s managed to get itself into an uncomfortable position. But someone managing his own money won’t be wasting it on stunts such as subsidising other people’s early retirements/redundancies, or on any equivalent to “pension spiking”. So I agree: 20% is a reasonable first guess.

• 20 zxspectrum48k September 22, 2017, 1:34 pm

I like this retirement planner (note I have no association with this company)
http://www.flexibleretirementplanner.com/wp/

For personal use this is free to download. It’s built for US individuals (mentions 401k etc) but can easily be ‘bodged’ to work for the UK. You can put in expected portfolio returns over different periods, return vol assumptions, inflation levels, inflation vol, tax rates etc. You can customize the cashflow streams to take account of things like school fees, state pensions etc. It runs a simple Monte Carlo to give you a success rate but also you can generate heat maps to looks at the sensitivities to various assumptions. A doddle to use.

I built spreadsheets to do most of this earlier in my life and they clearly have more vastly more flexibility but given the huge uncertainties in the input parameters I tend to think something like this is pretty much already overkill.

• 21 ermine September 22, 2017, 7:00 pm

@The Rhino

“The number on your pay check is therefore the number you need to beat.”

couldn’t agree less

Me too. I have five years experience of it now and I can’t actually imagine how I’d spend 100% of my erstwhile salary. I’ve been under half for all the time. I’m probably underspending and need to adjust up but while I was working –

I was paying down a mortgage
I was paying into a pension and/or saving up more, particularly at the peak earning time
I was paying loads of tax before I wised up to AVCs to help with that
I was paying fair amounts of NI as a PAYE grunt

In addition, the sorts of things I spent money on as a wage slave were much different from the retiree me. Holidays were fast and furious and dear because of it, I spent too much on consumer frippery to make up for the drudgery and other consequential costs of working all went into the pot.

As a retiree it’s who I’m with and how I spend my time that seems to matter more that visiting far flung places. Working is a terribly unfrugal occupation IMO 😉

• 22 The Investor September 23, 2017, 8:48 am

@therhino @ermine — I’d agree that a straight swap replacing your annual income with passive investment income is a big stretch and more than what most people require for a traditional retirement.

But that article is much more aspirational. 🙂 It’s much more about financial freedom. And it’s much more about getting to a point where you can keep living the life of most of your friends/peers when you do so, rather than getting by on less. Finally, it hails from a time when I was all about achieving that at an early age. In those days Monevator was going to be much more about increasing your income sources, starting small side businesses etc, though that has fallen by the wayside a bit. (The only time it mentions “retire” is in the headline, and that hails from an update — you’ll see the URL doesn’t mention it).

Very glad a frugal retirement is working out for you @ermine. And yes, that you don’t feel it’s a sacrifice etc etc. My co-blogger @TA is much more in the ‘life isn’t stuff, buy all your furniture second hand, and live like happy students when you retire’ school of thinking, and I have no argument with it. But it’s not the only definition or route to financial freedom.

• 23 Egremont September 23, 2017, 1:49 pm

Good article

Firecalc https://www.firecalc.com/ gives percentage probabilities of not running out of money within 30 years for portfolio size x and expenditure y. Its basic assumption is you are 75% equities/25% bonds – I think you can adjust that, but I haven’t investigated because I am 75%/25%.

• 24 Joe September 23, 2017, 4:41 pm

I think you are belabouring the obvious. All calculator say that the figures you are invited to input are assumptions and everyone knows assumptions have risk.

• 25 Prospector September 24, 2017, 9:04 am

The yield after inflation on 30y UK government bonds is currently around -1.5%.

For me, as a saver, this is a terrifying number. It means
a) There is no risk free asset when saving for retirement – guaranteed inflation protection comes at a capital loss
b) I massively need to increase the amount I need to save before becoming financially independent
c) It turns common sense strategies on there head – is it rational to invest in a 80:20 equity bond strategy when the bonds are expected to provide a negative real return – making risk return decisions very difficult.

Even the more sophisticated retirement simulators that allow for variation in returns I think are giving too optimistic a view as they generally use historical returns which don’t have many data points which start with such unprecedentedly low bond yields.

• 26 Mr Optimistic September 24, 2017, 10:33 am

@Prospector. Not sure I follow. Was that a 30yr IL gilt you had in mind? The point I think about a negative real rate of return isn’t that it leads to a (real) capital loss, rather it shows that the inflation protection has been reduced, so you are getting partial protection not full protection. An earlier article here said that IL gilts protect against unexpected inflation, which I had not thought about but agree with. So if inflation takes off, the -2% handicap may not be that big a deal.
Also, if you are still accumulating not sure that IL gilts would be a central consideration.
The 80:20 ratio is based on back studies which show that adding bonds reduces risk (by which I think they mean volatility) without sacrificing much by way of return. This is down to correlations which, as you suspect, may not currently be as in the past. Hence the view that cash might be a better alternative to bonds (for now).
In my view inflation and deflation are both plausible risks. This makes asset allocation a bit tricky!

• 27 Prospector September 24, 2017, 6:44 pm

@Mr Optimistic, yes real yield on index-linked gilts. Investing for 30 years at -1.5% (real) results in 64% of your capital in real terms. This seems a huge price to pay for diversification.

• 28 Mr Optimistic September 24, 2017, 7:40 pm

@Prospector. Yes indeed it does. However if your timeframe is that long, not sure why IL would feature. I am in a different boat as I will shortly need to invest a DB transfer. My sophisticated approach is likely to be one third cash ( not permanent I hope), one third equities and one third IL, the latter being 70% direct holding maturity 12 ish years, the rest in an L&G global IL fund of shorter duration.
If inflation gets out of control, the spike up in demand and price may wipe out the gloomy steady state prediction. If not, well that’s diversification for you!

30 years is a longggggg time.

• 29 Linda September 29, 2017, 2:28 pm

Surely you mean 5k per month? Unless you have other sources of support ?