How much money do I need to retire? This question confronts every worker over the age of 40 at one point or another, and the answer is usually provided by one of the many free retirement calculators available online. But how do these retirement calculators work, and can you actually rely on the answers they provide?
To most people a retirement calculator is like a black box - a mystery. It requires you to input a few numbers and then press "calculate". But what really happens behind the scenes? How does the calculator process those numbers and return an estimate for how much retirement savings you need? These calculators appear simple to use on the surface and provide mathematically precise output - but are the answers accurate?
The surprising truth is the apparent precision of online retirement calculators is actually their deception and downfall. The singular output perpetuates the illusion that you have one magical number providing the definitive answer to "How Much Money Do I Need To Retire?" In fact, it doesn't actually work out that way. The scientific facade is deceiving. Like any computer generated answer it is a matter of garbage in equals garbage out. The output of a retirement calculator is only as accurate as the assumptions underlying the calculation.
Let's look more closely at exactly how retirement calculators work and what assumptions they require to better understand this problem.
The Required Assumptions For Retirement Calculators
To make a retirement calculator do its magic you must first provide a few pieces of information. In fact, there are six questions that you must either answer directly or the calculator assumes the answers for you.
- How much will you spend each year during retirement?
- What will be the inflation rate each year during retirement?
- On what date will you and your spouse die?
- What will your annual income be from sources other than retirement savings (pensions, annuities).
- What will be the compound investment return on your savings during retirement?
- What year will you retire?
You probably realized when reading through this list that you can't possibly answer any of these questions - except for maybe the last one - with any degree of accuracy. Amazing, isn't it? Not only can you not answer these questions, but nobody else can answer them as well because it would require either a direct connection to the Higher Power or a crystal ball to forecast the future.
Think about the insanity of this situation: you are being asked to predict the future for five very complicated and unpredictable issues in order to make a retirement calculator work. The greatest economists in the world can't tell you what the inflation rate or expected investment return will be for 30 years into the future (not to mention all the other variables involved). Nobody can do it - your broker can't, your financial planner can't, and neither can you. Anybody who believes otherwise is either self-deceived or a liar. Yet, that is what a retirement calculator requires you to do to make it work.
This is critically important to understand because small changes in any one of these variables compounded over 20 years of saving and 30 years of retirement can have a dramatic impact on how much money you need to retire. In other words, the only way a retirement calculator can be accurate is if the inputs are accurate. Small inaccuracies multiplied over long periods of time cause such dramatic inaccuracies in output it can literally make or break your retirement security.
A Closer Look At Retirement Calculator Assumptions
Let's take a closer look at a few assumptions required by retirement calculators so that you can better understand how they work.
One of the more entertaining assumptions required by retirement calculators is life expectancy - how long will you live? The approach traditional financial planning takes to answer that question is to use life expectancy tables and then adjust the average life expectancy number up or down based on current health and family history. The problem with that approach is it only works for large numbers of people on average: it has no relevancy to any one person's expected death date.
You are no more likely to die at the average age determined by actuarial tables than you are to die 15 years earlier or 15 years later - and that 30 year spread could make or break your financial security. It takes a lot of money to support 30 years of life, and the truth is you have no idea how long you will live regardless of what the actuarial tables say. Your personal date with destiny is not an actuarial event. It cannot be probabilistically determined, and yet that is how traditional financial planning approaches the problem.
If financial security is your goal then the only realistic choice is to assume a very long and healthy life unless family history or personal health dictates otherwise. Half the people will outlive the averages and your objective is to be part of that group. In addition, average life expectancy is constantly growing and will likely be much higher by the time your death makes you part of that average. Put these two statistical facts together and the only reasonable conclusion is to assume a very long life when working with a retirement calculator. Anything less is financially dangerous.
Another example to help you understand the issues with how retirement calculators work involves estimating the expected inflation rate. The world's greatest economists are consistently wrong at predicting inflation; yet, you are somehow expected to predict it 30-50 years into the future in order to determine how much money you need to retire.
Traditional financial planning answers this question by assuming recent historical inflation - usually 3%. Unfortunately, this is a very dangerous assumption because inflation has varied considerably from recent history. There have been brief periods where inflation reached double digits during war times and periods of negative inflation during credit collapses. In addition, there have been extended periods of inflation considerably higher than the commonly assumed 3%. Today, many credible economists are predicting inflation in excess of 3% over the next 15-30 years (a time period relevant to most retirees) due to excessive government debt and entitlement program funding problems.
This is important to understand because underestimating inflation is no small risk when working with a retirement calculator. You may not think the difference between 3% inflation and 6% is anything to worry about but it will literally destroy half your savings in roughly 24 years. That is a big deal.
The lesson here is that small inaccuracies when estimating inflation as well as investment return can compound into dramatic, huge differences in the amount of retirement savings you need to be financially secure. This difference can balloon a $700,000 required nest egg into $2,000,000 or more. But don't take my word for it: instead, try it for yourself by plugging a few variables for inflation, investment return and life span into your favorite retirement calculator and see how it works for yourself. In the next section you will learn how to do this in a way that produces results you can rely on...
The Solution
The truth is retirement calculators are simple input-output equations. The numbers provided by calculators are only as accurate as the input assumptions they are based upon.
So how can you estimate how much money you need to retire when the process requires assumptions that are impossible to estimate accurately? The unfortunate truth is there's no definitive answer. It is essentially a question about the future and the future is unknowable. Retirement calculators and financial planners will give you answers that appear scientifically accurate - but they are no better than educated guesses and your retirement security deserves better.
The most viable solution given the inherent uncertainty baked into the process is to create a realistic range of assumptions and plug varying combinations of those assumptions into your favorite retirement calculator. The technical term for this is building a confidence interval. Combine all the optimistic assumptions (low inflation, high investment return, early death) for each variable to create the extreme low end estimate for retirement savings required, then combine the pessimistic assumptions (high inflation, low investment return, long life) to create the extreme high end estimate.
Reality will likely end up being somewhere between these two estimate extremes. Once you have a confidence interval you can then plot your current savings within that confidence interval to know how much risk you are taking. If you have enough money to reach the upper end of the confidence interval then your retirement is likely secure: the opposite is true if your savings is near or below the low end estimate. This will give you some idea if you should delay retirement in order to increase savings thus reducing risk. Alternatively, you could choose to work part time to take the pressure off your savings. Either way, a confidence interval will allow you to measure the risk of coming up short with your current retirement savings program.
The key point is to realize retirement calculators are not the exact science they appear to be on the surface. The inner workings of these black boxes is just a simple math formula that blindly converts assumptions about the future into an estimate for future savings needs. While retirement calculators are useful to simplify the process of crunching the numbers and creating estimates, don't believe there is one and only one answer. There is a range of answers - each providing a different level of confidence so that you don't outlive your savings.
About The Author
Todd R. Tresidder wrote the ebook How Much Money Do I Need To Retire explaining how financial calculators work and providing step-by-step solutions so that you can retire with security and confidence. His website offers a variety of resources on personal finance, retirement planning, wealth building and investment strategy. He lives in Reno, Nevada with his wife and two children.
