The process is deceptively simple on the surface…just plug a few numbers into your favorite retirement calculator and within seconds you have a mathematically precise answer showing how much money you need to retire. Millions of people (including highly qualified financial planners) follow this exact process and bet their retirement security on the result every year. But, is it accurate? Can you actually rely on what it tells you? Unfortunately, like so many things today, it’s not as simple as it appears…
Hiding behind this facade of simplicity is a complicated maze of assumptions that can invalidate the results produced. Every retirement calculator, whether state-of-the-art Monte Carlo or old-school rules of thumb, must make certain assumptions in order to complete the calculation. There are no exceptions, and the accuracy of these assumptions can make or break your retirement security.
Let’s look a little closer at five of these assumptions, so you can decide if you should rethink how much money you need to retire:
Life Expectancy Assumption: How Long Must My Money Last In Retirement?
Most financial planners and retirement calculators assume a “normal” life expectancy unless health concerns merit a different conclusion. Normal life expectancy is determined by consulting actuarial tables like those used by the IRS or insurance companies to determine average life span.
This sounds reasonable on the surface but is fatally flawed from an individual retirement planning standpoint. Actuarial tables are only valid when applied to large numbers but have zero validity for any one person’s retirement. The truth is your date with destiny is no more likely to occur at the statistical average than any year before or after that date. Planning on an average lifespan is completely misleading and can cause you to dangerously underestimate savings needs.
In fact, roughly half the people will live less than the average and half the people will live longer than the average (and your goal is to end up in the second half). Today there is a 60 percent chance that one member of a couple at age 60 will make it to 90 or beyond, and this number is growing. Obviously, that is much older than the averages would indicate requiring much greater retirement savings.
In addition, the averages are rising every year. Longevity has been increasing by roughly 100 days per year for the last 100 years adding 30 years to life expectancy in the last century. With breakthroughs in biotechnology and nanotechnology, it is completely reasonable to expect the averages to grow at an accelerating rate adding many years to your life beyond what the actuarial tables would indicate based on today’s data.
In short, planning your retirement based on today’s average life expectancy is a dangerously misleading practice that could cause you to run out of money when you need it most.
Inflation Assumption: What Is A Reasonable Estimate For Inflation During Retirement?
Inflation is a required component of every estimate for how much money you need to retire and potentially the biggest risk to your retirement security. The reason is simple – it is a number that affects the compound growth of your money which in turn causes small changes in inflation to have surprisingly huge impacts on the savings required.
Most advisers and online retirement calculators assume 3% for inflation because that is the average during the recent past – roughly 20-30 years. But the history of inflation has not always been so sanguine. In the 1970’s prices doubled in one short decade cutting the purchasing power of your savings in half! Additionally, economic fundamentals have changed in recent years making the last 30 years a potentially poor indicator for the future.
The credit crunch that began in 2008 caused ballooning government debts and deficits with all the stimulus programs and bank bailouts. Combine these facts with mushrooming entitlement programs like Social Security and Medicare that face financial problems, and it may be prudent to budget for higher inflation rates than recent history would indicate.
Remember, small changes in inflation that seem benign can cause dramatic changes in how much money you need to retire because the difference compounds making it multiplicative. If you’re not clear how this works, it is best to prove it to yourself using your choice of free retirement calculators that allows you to conveniently vary individual assumptions while keeping the others constant.
For example, try varying inflation between 3% to 7% while also varying longevity assumptions to provide for at least one spouse reaching age 95. It is a worthwhile exercise that might just surprise you by how much it changes the amount of money you need to retire.
Budget Assumption: Is 80% Of Current Spending Really Enough Money To Retire?
The conventional wisdom in retirement planning is to assume 80% of current spending as a reasonable approximation for your retirement budget. Unfortunately, research contradicts this all-too-common assumption.
Sure, some expenses will drop during retirement like commuting costs, business clothes, not to mention your retirement savings contributions, but other expenses are just as likely to increase. For example, it is not uncommon for the first decade of retirement to cost more than your working years because of active lifestyles, costs associated with new interests and hobbies, increased travel expenses, and more.
The good news is that evidence does support retirement spending decreasing with aging; however, the bad news is other research indicates this benefit is largely offset by rising medical expenses, prescription drug costs, and inflation.
In short, you would be wise to formulate your own retirement budget based on your personal plan for retirement. Some people will spend less and others will spend more than they did during their working years, but blindly assuming 80% of pre-retirement income as being enough because it is conventional wisdom can be very dangerous and potentially misleading.
Annual Income Assumption From Sources Other Than Retirement Savings
Many people make two income assumptions when planning retirement: they assume zero earned income, and they assume Social Security and pensions will be a stable source of income. Both of these assumptions are questionable in today’s rapidly changing world.
The pension and Social Security issues are complex topics that require more column inches to develop than are available here. If your retirement planning includes either of these sources of income then you will find a complete discussion of this topic in this list of retirement planning articles. Suffice it to say that both of these sources of socialized retirement planning are on the way out and are rapidly being replaced by individual retirement plans. This places an increasing burden on your savings, but exactly how this affects you will be determined by your age and specific situation.
Another result of increasing longevity is that many people are rethinking how they define “retirement.” In the past retirement was synonymous with never working again and living the pro-leisure circuit of perpetual golf or savoring little drinks with umbrellas while lounging on the beach. The implied assumption was that you would work like a dog for 40 years so that you could save enough to do absolutely nothing of substance for all your remaining years. With many people facing retirements almost as long as their careers that assumption is being challenged today.
The new retirement is about phased worked schedules, encore careers, and endless variations on the theme of creating a life you love so much that you would never want to retire from it. The truth is 30 years of doing absolutely nothing of substance is not how most people would define a satisfying and fulfilling life. You can only travel around the world so many times and play so many rounds of golf before unsettling questions begin to surface.
Many people want more connection and sense of purpose to their lives than perpetual leisure provides. Vacation is best enjoyed when punctuated by meaningful work. 30 years is too long to sit around doing nothing causing many people to seek alternative ways to connect to their community and produce earned income that supplements their retirement budgets.
In short, your assumptions of never earning any money after you retire or being able to rely on your pension and Social Security income may not be accurate. You should revisit your retirement plan by varying these assumptions and see the impact it has on how much money you need to retire.
Return On Investment Assumption: How Much Will My Savings Grow During Retirement?
The state-of-the-art answer to estimating how your portfolio will perform during retirement is based on assumptions derived from long-term historical average returns. Some retirement calculators apply longer historical data periods, others use simple average returns, while the most sophisticated calculators randomize and distribute the returns Monte Carlo style to give a confidence interval.
In the end, however, all of these calculators are nothing more than a variation on the “backcasting” theme where the assumption is that future investment returns will have some relationship to historical investment returns.
The problem is your retirement security is dependent on how your portfolio will perform during the next 15 years – not how it theoretically would have performed for the last 100 years. The past is not the future and no amount of historical evidence can provide a crystal ball that manages unforeseen risks. For example, people who retired in the late 1990’s have endured 10 to 15 years of volatile and lackluster equity performance where cash has outperformed stocks and bonds have performed best out of all three. Historical averages would not lead you to expect this outcome.
This “lost decade” of portfolio under-performance has serious implications for retirement planning. Not only did the portfolio earn way below historical expectations but retirement spending draws down the remaining balance. For example, assume a retiree spends 3% of his starting savings balance each year (a common assumption) and endures 15 years of zero portfolio performance (as shown by recent history). This creates a 45% reduction in assets (3% x 15 years) without assuming any investment losses. This would be devastating to most retiree’s financial security.
Like the inflation assumption, the return-on-investment assumption is particularly important to how much savings you need to retire because the effect is compounded. Small changes in return on investment cause dramatic changes in your savings requirements.
What we have learned is there are many hidden assumptions behind the apparently simple calculation determining how much money you need to retire. We have also learned that the industry standard approach to choosing values for these required assumptions is questionable at best and downright dangerous at worst.
For all these reasons you may want to revisit your retirement calculations and vary the assumptions to see how it can affect your personal situation. The devil is in the details, and the process is not as simple or scientifically accurate as the financial planning community would lead you to believe.
About The Author: Todd R. Tresidder is a retirement coach who walks the talk after retiring at age 35 and adopting the “New Retirement” lifestyle. He lives in Reno Nevada with his wife and two children where he publishes advanced personal finance articles and ebooks.
(photo credit: theproadvisor)