Retirement Calculator Wisdom from Nest Egg GuruSubmitted by Financial Planning Hawaii on September 10th, 2013
There is no shortage of online calculators that purport to help users accumulate retirement savings and/or plan for spending it down. There is, however, an absolute dearth of calculators that truly serve these functions well. It is for this reason that I was compelled to create Nest Egg Guru. With that in mind, the purpose of this post is to help inform and educate readers about the characteristics of a sound retirement planning calculator app and how to properly interpret the calculator’s output. Here’s what you need to know:
Calculators that require the user to enter an expected annual rate of return may be hazardous to your financial health! The mathematical failing of these programs is that they do not account for the possibility of negative returns. To illustrate this point simply, a $1 million portfolio that declines by 50% one year and rebounds 60% the next year has an arithmetic average return (the return methodology used in the calculators) of 5% per year, but is only worth $800,000 at the end of year two. Unbelievably, many of today’s most popular free online retirement calculators make projections using arithmetic mean returns. The failure to account for periods of negative returns, particularly early in retirement, is an enormous flaw and can lead users to reach overly optimistic conclusions about their income sustainability.
The reliability of the calculator output will depend a great deal on how closely the model portfolio used in the application reflects your actual real-world portfolio. Many of today’s most popular calculators fail to account for such important inputs as investment expenses and the relative weightings of multiple asset classes. Such shortcomings can lead to enormous differences between the calculator’s output and what your portfolio experience would have been under the same market conditions.
Retirement calculators have almost no predictive value. This may come as a shock to some readers, but no calculator is a crystal ball. The mere fact that future returns are inherently unknowable and unpredictable make this concept intuitive. It is for this reason that I take a dim view of retirement apps that purport to generate a single magic retirement number or probability. Instead, the best calculators – and Nest Egg Guru does this well – present the users with a range of values in which their portfolios may be likely to fall.
The highest use of a good retirement calculator is as a tool for testing your portfolio under adverse investment conditions. Most people are not worried about having too much money in retirement, but rather they are worried about having enough to last. As such, the most useful calculators are those that illustrate how one’s portfolio may fare under difficult conditions. At Nest Egg Guru, we encourage users to consider the worst 50% of the 5,000 simulation results.
The next highest use of a good retirement calculator is as a tool for illustrating the effects of changing the user’s input parameters. Understanding the impact that variables within the user’s control may have on the results can be of enormous planning value. At nest egg guru, we encourage users to test how changes in contribution/withdrawal amounts, inflation adjustments, asset allocation and investment expenses may affect the outcomes.
Calculators that employ historical backtesting are fun to use, but are overly optimistic. While it may be interesting to see how your portfolio might have held up under various through previous stressful periods of time, the problem is that such calculators do not allow for the possibility of circumstances that may be worse than the historical experience. For instance, many people believe that the worst 30 year period to have begun retirement is the one that began with the 2000-2002 bear market. However, we will not be able to test this notion until 2030.
Not all Monte Carlo Simulation Calculators are the same. Calculators that apply a form of statistical analysis called Monte Carlo simulations are generally regarded as the most reliable engines for retirement planning calculators today. However, there are different kinds of Monte Carlo analyses. Most calculators today base their Monte Carlo simulations off of internal assumptions about future market returns and volatility characteristics. However, errors in these assumptions still leave the user vulnerable to garbage-in, garbage-out results. Alternatively, Nest Egg Guru is one of just a handful of retirement planning applications to employ a form of Monte Carlo analysis that does not require either the user or the application to make specific assumptions about future rates of return.
While all of this detailed information about retirement calculators may be “TMI” for some readers, my sense is that most people who use them as a planning tool are wholly unaware of just how unrealistic and unreliable they may be. Nest Egg Guru has been engineered to be a better retirement planning mousetrap. Try the current beta version at www.NestEggGuru.com. Major upgrades are coming soon too.
IMPORTANT: The projections or other information generated by Nest Egg Guru regarding the likelihood of various investment outcomes are hypothetical in nature and do not reflect actual investment results. While Nest Egg Guru believes the information presented may be instructive in helping users plan for retirement, it is important to understand that no calculator can guarantee future results (i.e., Nest Egg Guru is not a crystal ball). Similarly, it is also important to understand the limitations of this any other retirement calculator application. First, while considerable thought has gone into designing portfolio models that realistically represent individual investor experiences, the degree to which the index models used in Nest Egg Guru differ from the actual users’ portfolios may affect the applicability of the results. Additionally, the choice of indices and the time periods from which the monthly index return data were sampled may have an effect on the outcomes and might produce different results if different indices and/or time periods were chosen. Further, because Nest Egg Guru’s results are from historical returns data, there is an underlying assumption that future returns will at least be somewhat similar to what they have been in the recent past (i.e., the last 40 years). Lastly, while Nest Egg Guru believes the methodology chosen in this calculator has certain advantages, other calculators using different methodologies may produce different results. A more detailed description of the sampling methodology employed and of the underlying index models may be found in the “Simply the Best” section of this website.
The Nest Egg Guru calculators are made available to you as educational tools for your independent use and are not intended as a substitute for professional retirement planning guidance or advice. While it is hoped that these tools help you identify important factors to consider in planning your retirement, for specific portfolio guidance, users are encouraged to consult with a trusted financial planning professional.