It seems it should be simple.
Just punch a few numbers into the retirement calculator and the computer tells you exactly how much money you need to retire.
Every day this process is repeated in financial planners' offices throughout the world. It is industry standard practice, so what could be wrong with that?
And we're not talking small differences either. The actual savings you need to retire could be more than twice your current estimate or less than half your current estimate, and you won't get to know until it is too late.
It's a huge problem that jeopardizes your financial security. Let me explain...
Garbage In Equals Garbage Out
The problem is simple once you understand it.
Calculating how much savings you need to retire requires seven basic assumptions, and the calculation is only accurate if those assumptions are accurate. That's because your retirement estimate is nothing more than a mathematical projection of the assumptions -- garbage in equals garbage out.
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If just one of your assumptions is wrong, the entire calculation is wrong.
Worse yet, two of these required assumptions are critically important because they have a compound effect, so if they are wrong by as little as 1-2 percentage points, the impact on your retirement savings estimate can the difference between dining on filet mignon or cat food.
Let's be clear. This is not about being an alarmist. Retirement calculators are useful tools because they reduce complicated long-term planning into a simple-to-execute action step that most people can complete.
Unfortunately, this simplicity comes at a price and that is what causes the problem.
In a nutshell, this simplicity isolates you from developing a deeper understanding about retirement calculators and potentially blindsiding you to the inherent risks. It is easy to fall prey to the apparent accuracy implied by the scientific facade of computers without understanding one key mathematical truth: The only way your magic retirement number will be accurate is if the future matches the assumptions built into your retirement estimate.
Unfortunately, the chances of that occurring are close to zero. But don't take my word for it. Decide for yourself as we look at seven main assumptions behind estimating how much money you need for retirement so you can decide if your magic number is reliable... or not.
The 7 Critical Assumptions Behind How Much Money You Need To Retire
1. What age will you and your spouse retire -- whether it is voluntary, due to unexpected sickness, or due to layoffs? This first question -- "When will I retire?" -- seems as though it should be reliably within your control.
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After all, you choose your retirement date, right? Unfortunately, it's doesn't always work that way. Many workers are forced into early retirement due to unexpected layoffs or sudden illness with serious financial implications.
Like so many assumptions in retirement planning, something that appeared reasonable at first glance looks far less reliable upon closer inspection.
2. What amount of money will you spend every year from the day you retire until the day you die? Industry standard practice assumes 80% of your pre-retirement income, but many new retirees find travel and outdoor recreation costs actually increase expenses instead of lower them. To make matters more confusing, research by Ty Bernicke showed retirees reduced spending 25% for each decade during retirement. Unfortunately, he failed to adjust for , which would likely offset any spending reduction. The is your spending patterns over 30+ years of retirement are an unreliable guess. Nobody knows. If you are not clear about this truth then just think back 30 years and try to imagine your spending today. Would you have guessed accurately? What does that imply for the next 30 years?
3. What will be the inflation rate during your retirement years? This is one of those two critically important numbers that has a compound effect on your retirement savings estimate and must be accurate. The problem is Ph.D. economists can't predict inflation accurately for even one year, thus making a 30+ year estimate all but meaningless. The industry standard solution is to use historical average inflation but our unprecedented government debts and deficits, resource depletion, and changed economic landscape casts serious doubt on the applicability of historical inflation as a model for future inflation. More importantly, a small 1-2% error can double (or halve) your retirement savings estimate making this assumption a particularly serious problem.
4. In what year will both you and your spouse die? The industry standard solution is (again) to apply historical statistical averages -- life expectancy tables. This works fine for the IRS and insurance companies because they work with large pools of people, but it has zero validity for any one individual. Your date with destiny is a binary result, not a statistical result. This means you are either 100% dead or alive - not 54% dead at age 83. Similarly, you are no more likely to die at the statistical average age than any other year of your life. The whole concept of applying statistical life expectancy to any one individual is nonsense. Similarly, any retirement estimate based on a life expectancy table might be financially hazardous to your wealth.
5. How much will company pensions and Social Security pay over the of your retirement? When estimating how much you need to retire, you must first figure how much income you will get from various other sources -- company pensions, government pensions, and Social Security -- in order to determine how much income your personal savings must provide to cover the income shortfall. Unfortunately, these income sources aren't reliable. Corporations are notorious for raiding their pension funds, underfunding pension liabilities, and absolving themselves of pension obligations through legal shenanigans. Always remember that the company pension remains the company's asset and merely a "legal " to you. It can all be changed with the strike of a pen; therefore, it is not as secure as an asset you personally own like a 401(k). If you think I'm being overly cautious, just ask the airline employees union or any other victim of corporate reorganization. Similarly, Social Security's problems are no secret. The government is already taking action to reduce benefits by increasing age qualifications and changing inflation indexing formulas. You should expect more of the same causing a reduced payout over time. Bottom line is you would be wise to place a conservative valuation on pension and Social Security payments. There are good reasons to believe these obligations may not be as rock-solid as you would like.
6. What will your investment portfolio earn over your remaining lifetime? Investment return is the second of the two critical numbers that have a compound effect on your retirement savings estimate. Small errors in this number compound into huge differences in the savings required to secure your retirement. The problem, of course, is nobody can accurately predict investment returns one year into the future, so 30+ years is patently impossible. In the end, your investment return is a function of your investment strategy, skill, and the time period you began investing. It is a bet on an unknowable future. If your annual estimate is just 1-2 percentage points off, it can double (or cut in half) the amount of money you need to retire. This is clearly problematic since such errors are not only possible, but likely.
7. What will be the sequence of your investment returns in the first 15 years of retirement? It's not just enough to know your investment return (which you can't know anyway): You also have to know the order of those returns.
Independent research by Michael Kitces, Wade Pfau, Ed Easterling and more support a similar conclusion: 80% (or more) of the risk of financial failure during retirement is determined by the first 10 to 15 years investment returns. Similarly, the first 10 to 15 years investment returns is the primary determinant behind how much income you can safely spend from savings every year without running out of money before you run out of life. The only problem, again, is nobody can predict with certainty if their first 15 years will see above average or below average returns. It is unknowable -- as is every other key assumption in the calculation for how much money you need to retire.
The Key Is The Assumptions -- Not The Calculator
Not to be a pessimist, but can you see why this is not the exact science that books, calculators and financial planners lead you to believe? None of these seven questions can be answered with certainty, yet all of them require accurate answers or your estimate will be wrong.
The problem is every one of these questions requires you to make an assumption about the future, and the future is unknowable.
Some proponents of the status quo might claim these problems are solved by their particular brand of retirement calculator -- Monte Carlo, valuation driven, historical backcasting, etc. The problem is all of these calculators produce statistically similar results because they are all essentially the same calculation requiring the same inputs while varying just one or two of the seven required assumptions. In other words, they are more similar than different.
The key to an accurate estimate has little to do with the calculator and everything to do with the assumptions you choose for the calculator.
The industry standard approach is to choose expediency over accuracy by applying some variation of historical averages. This solution sounds logical at first, but is dangerously misleading.