The first step in retirement planning is to estimate how much money you need to retire. This is actually a fairly straightforward task because there are simple mathematical formulas and easy-to-use online retirement calculators designed to help you. The process is well understood and the tools are easily accessible on the internet.
What is less well known, however, is how these calculators work and the inherent problems involved in using them correctly. In other words, it is easy to create a retirement estimate but surprisingly difficult to do it accurately.
The reason it is difficult to create an accurate estimate for the money you need to retire is because the accuracy is dependent on the assumptions you use. Many people fuss over whether to use elaborate models like Monte Carlo or simple rules-of-thumb like the 4% rule, but that is missing the forest for the trees.
Huge differences in your retirement planning estimates occur when you vary the assumptions used for spending (have you succeeded at paying off your mortgage?), income, inflation, and other required inputs. The unspoken truth about retirement planning is the validity of the assumptions used to determine how much you need to retire will make or break your financial security.
The Inherent Problem With Making Retirement Assumptions
Below are the six common assumptions required by nearly all retirement calculators to determine how much money you need to retire:
- Annual spending budget
- Estimated inflation rate
- Expected lifespan
- Annual income from sources other than savings
- Estimated return on investment
- Expected retirement date
As you read through this list of assumptions you probably realized something – they can’t possibly be answered accurately. Think about it. All but one requires you to predict the future—something no one can do reliably without a crystal ball. In fact, only one question can be answered with confidence because it is the only one you have any control over (number 6 in case you haven’t guessed).
Amazingly, conventional retirement planning requires you to provide assumptions that are impossible to estimate accurately in order to determine how much money you need to retire. It is insanity. If you vary these required assumptions within a reasonable range of probable outcomes you will find the estimate for your retirement savings can vary by two to three times the original amount.
In other words, one set of assumptions might result in $750,000 of retirement savings needed, and an equally plausible set of assumptions might estimate $2,250,000 in required savings. The difference is huge, and yet both set of assumptions are equally likely to be true. The whole process can leave you wondering what is the real retirement number and how can you ever retire in confidence?
Below we will look at each of the assumptions necessary to accurately answer the question, “How much do I need to retire?” so that you can better understand the issues involved.
How To Estimate A Spending Budget For Retirement
Most traditional retirement planning models assume you will need 75% to 85% of your working income in order to maintain your standard of living after you retire. The idea is that you will save on work-related costs like commuting and a professional wardrobe, as well as the expense of raising children. The formulas also generally assume that your home will be paid for and you will enter a lower tax bracket.
The truth is every individual has a unique set of circumstances that affect retirement spending. Today’s retirees lead longer and more active lives driving up the total cost of living in retirement. The expenses of hobbies, leisure activities and travel can easily offset any decrease in work-related expenses.
Your health care expenses are also likely to increase as you age, not to mention the price of long term care if you don’t have insurance to cover that. If you still have a mortgage on your house or a child in college, your expenses during your first few years of retirement may be equal to or greater than before.
The reality is you must plan a personalized retirement budget that reflects your unique plans for retirement. Some will spend more than their current income during retirement, and some will spend less. The research on retirement spending indicates a wide variance in retirement spending patterns with most people reducing spending as they get older. Any way you look at it, the 75-85% rule-of-thumb is a dangerous assumption that is best ignored.
Reasonable Assumptions For Inflation During Retirement
Most retirement calculators assume a modest 3% inflation rate. This is based on recent history (the last 20 years or so) and implies that your spending in nominal dollars will roughly double every 24 years.
The problem is if inflation increases to 6% (not a far-fetched possibility) then your spending will double every 12 years instead. That obviously makes a very big difference in how much you need to save for retirement. Rather than watching your expenses double once or maybe twice during retirement you could see them double 3 or 4 times which would drastically affect what you could afford to spend.
Historically, inflation has fluctuated from negative numbers to double-digits during wartimes and has shown prolonged periods of higher rates than the commonly assumed 3%. Given current conditions with high government debt and deficits combined with entitlement funding problems, many credible economists predict increased inflation over the next 20 years.
So how much will you assume for inflation when calculating how much money you need to retire? A percentage point or two can make a dramatic difference. I suggest using a range of assumptions varying from 3% on the low side up to 6% on the high side depending on how conservative you want to be in your retirement planning.
How To Estimate Life Expectancy
Isn’t it amazing that retirement planning requires you to estimate your life expectancy? Talk about an impossible task.
Sure, you can estimate your lifespan based on family history and your current health and medical conditions, but no one can possibly know how long they will live with any confidence. There is zero actuarial validity to estimating a single lifespan. You are no more likely to live until age 80 than you are to die tomorrow. For any one person life expectancy is random. It is only a valid statistical concept when large numbers are involved – not individuals.
Yet life expectancy has a major impact on figuring how much to save for retirement. The reason is because funding 20 years of retirement is dramatically different from 40 years or more. In the first scenario you can spend principal and the effects of inflation are reasonably manageable, but in the second scenario you not only can’t spend principal but you must also develop a perpetual income stream that grows faster than inflation. In short, different life expectancies imply dramatically different retirement savings requirements.
The conservative solution is to assume the best and plan on a very long life – longer than the actuarial tables estimate. If you come up short the worst that will happen (besides dying early) is you leave a nice legacy behind. If you live a full, long life you will need every penny. Many complain that a long life expectancy pushes retirement savings goals out of reach, but the truth is roughly half those people will outlive the averages and require the greater savings anyway.
Estimating Income From Social Security, Pensions And Annuities?
While Social Security will not likely disappear altogether, the inflation adjusted value of benefits will almost certainly decrease – especially for those retiring behind the Baby Boomers. You can check your annual wage and earnings statement from the Social Security Administration to get an idea of how much you’ll receive when you retire. The younger you are today the greater the risk that the inflation adjusted value of your benefits will be less than currently estimated.
Pensions, particularly private ones, are also proving to be less reliable than they once were. Fewer companies are offering pensions in the first place, but even those with longstanding traditions of fat pension benefits are backing out of those obligations – just ask airline employees.
Sure, there are protections in place to ensure you don’t completely lose out on what was promised to you, but underfunding is a serious problem with the recent market declines. Should your company default on its pension plan you could be left with a reduced payout. If your pension is frozen, you will still be entitled to benefits already earned, but you will stop accruing additional benefits.
In other words, Social Security and pension income may not be as dependable as you thought placing a greater burden on your retirement savings.
What Will Be My Investment Return During Retirement?
Most traditional retirement planning formulas assume long-term historical returns from a traditional stock/bond portfolio of 7% to 10%, decreasing to 4% to 5% after retirement as you shift away from equities and toward fixed income.
The problem with these estimates is they are derived from super-long data periods irrelevant to most retirees. What retirees care about are 15-20 year periods – not 100 year market history – and the surprising reality is how variable the returns can be over 15-20 year time spans. Negative to flat returns are entirely possible but are wholly unexpected when using traditional retirement assumptions – just witness the last 10 years for the U.S. stock averages.
This is incredibly important because even small changes in return on investment can dramatically alter your retirement security. It is not realistic to blindly assume long-term historical returns when your investment time horizon is significantly shorter than the data assumes.
When Can I Retire?
Finally, a question you can answer accurately. You choose your retirement date and you are in full control of when that occurs. If you are somewhat flexible in deciding when to retire, you can significantly reduce the amount of money needed to fund your golden years. Working just a few more years allows you to continue building your portfolio while at the same time putting off drawing down your savings. If retiring is not optional, however, due to medical or other reasons, plugging this known figure into your retirement calculator will send you on your way to determining how much you need to save.
The key point to notice from this discussion is retirement planning is not nearly as simple as the financial calculators would lead you to believe. Sure, it is easy to create an estimate when saving for retirement, but creating an accurate estimate is an entirely different matter.
The fact is you need to make six different assumptions when calculating your retirement number; yet, only one of the assumptions can be estimated with any certainty. The rest require you to predict the future which is unknowable and impossible to do. Even the experts can’t do it – and neither can you or your financial planner. If you believe otherwise you are just deceiving yourself.
This is a big problem because the answers you assume to these questions will dramatically affect how much money you need to save so that you can retire with financial security. A small change in just one answer can vastly alter the resulting retirement savings requirement. In fact, I highly recommend you test this using your favorite retirement calculator and prove it to yourself. Don’t take my word for it.
Start varying the three most important and difficult assumptions – return on investment, life expectancy, and inflation – and you will be amazed at the dramatic impact it has on how much money you need to retire. Now, imagine if your estimates are off on all five of the variables—your retirement savings could be wildly off target forcing you to work longer, cut back on your lifestyle, or worse, run out of money before you run out of retirement.
What you will see when you complete this exercise is the traditional approach to estimating how much money you need to retire makes you completely dependent on how well your assumptions reflect your future retirement reality. In other words, you have to be able to forecast 20-40 years into the future. This makes the apparent scientific precision of retirement calculators far less scientific.