FMF readers may remember Todd from the following posts: How Much Income Do I Need For Retirement?, Why Calculate The Savings Needed For Retirement?, and Answer These Six Essential Questions To Determine Your Retirement Number. All of them are excellent resources IMO.
Now, here's the post. It's a bit long, but well worth the read.
Let me share a story with you. My Ultimate Retirement Calculator often gets featured in reviews about retirement calculators. All too frequently a misinformed writer wages criticisms like the following:
- It doesn’t include separate inputs for each spouse. (Answer: Who needs the complication? Just aggregate both spouses together. It’s called community property for a reason.)
- It doesn’t provide separate tax rates before and after retirement. (Answer: Who cares? Different tax rates would only be marginally meaningful if your income fell dramatically after retirement. Are you planning on poverty?)
- It doesn’t include varying asset allocation with age. (Answer: You can’t even model the performance of a single asset allocation accurately for 30 years. The idea that you can model a changing allocation with any greater accuracy is lunacy.)
The cause for this erroneous reasoning is they don’t understand how retirement planning math works in practice. All those little details are dwarfed in significance by one or two critically important “big numbers” that will make-or-break your analysis. Get these big numbers right and all the other details barely matter. Conversely, get just one of the big numbers wrong and your analysis will fail completely no matter how many small details you got right.
What are those critically important numbers?
Critical Number 1: Percentage of income saved versus income spent.
In the article on my website, How Anyone Can Retire in 10 Years (or Less!), I demonstrate how a super-aggressive savings rate would allow you to skip all the calculators by reducing retirement planning to one simple ratio that forecasts with scientific precision how long it takes to become financially independent. The numbers are as follows:
- 10% savings rate = 42 years
- 20% savings rate = 32 years
- 40% savings rate = 21 years
- 50% savings rate = 17 years
- 60% savings rate = 14 years
- 70% savings rate = 10 years
- 80% savings rate = 7 years
This is not some crazy math theory. It explains exactly how I retired at age 35. I saved roughly 70% of a substantial income and never allowed spending to rise with income. It didn’t take long for my assets to grow sufficiently large to support my lifestyle.
It’s a brain-dead simple, scientifically accurate way to retire young and know with certainty how much money you need to retire. No fancy math, impossible assumptions, or retirement calculators required. It just plain works.
The principle taught by this critically important number is if you want to retire faster, then reduce your spending or raise your income so your savings as a percent of income grows. The higher the percentage, the faster and more reliably you’ll reach the goal.
Again, don’t get hung up on distracting details. Just pay attention to your savings rate in relationship to your earnings and spending needs. It’s a critically important number.
Critically Important Number 2: Return on investment minus inflation.
The reason I spent so much time explaining the investment return assumption earlier in this book is because it’s the most important number (along with inflation) determining your retirement failure or success. The relationship between inflation and portfolio return will literally make or break your retirement. It is The Big One. Nothing else comes close when planning retirement with paper assets.
The reason is simple—compound returns multiply little differences into huge differences over long periods. This isn’t about turning mole hills into mountains; this is about turning grains of sand into the Himalayas. I’ll repeat that point for emphasis because I don’t want you to miss it. Both inflation and return on investment have a compounded effect on your estimate for how much money you need to retire. That’s why they’re so critically important.
But don’t take my word for it. Prove it to yourself right now. Go to my Ultimate Retirement Calculator and enter the numbers that best represent your life situation. Seriously, do it before reading any further. Don’t worry about perfection. Your best estimates from earlier in the reading are good enough for this exercise.
When inputting expected lifespan, use age 100 unless you have known health issues. Notice how the calculator allows you to reduce spending during retirement just like the research by Bernicke indicates. If you’re just reading along but not taking action, then you’re shortchanging yourself because you’ll get a lot more value from this if you do the exercise right now. Please, don’t just trust me; prove it for yourself. It’ll only take two minutes and could be the most eye-opening two minutes you spend all week.
Once you fill out the calculator with your base level numbers, then write down the “magic retirement number” that it provides.
Next, try perfecting your magic number by tweaking a few variables like tax rate, retirement age, and other details similar to the critical comments cited earlier. The only rule is you can’t touch the two key inputs highlighted in this chapter: return on investment and inflation. Everything else is fair game.
Notice that your magic number changes with each variation, but the changes are only marginal. Your estimates for how much money you need to retire remain in the same ballpark as your original number. The calculation is relatively stable.
Now, using the exact same inputs as before, raise your inflation rate by 2% while simultaneously reducing your return on investment by 2%, but make sure you’re sitting down first.
See what I mean? For most people, this small change will literally multiply the amount you need to retire several fold. It should knock your original estimate right out of the ballpark, over the river, and into the next state.
That is why I call all the other variables “details” and label these two ratios “critical.” It’s just the way the math works.
Principle: Small changes in a few key numbers multiplied over long periods of time have huge impacts on your ability to retire with financial security. Therefore, focus on those key variables and don’t worry about the minute details.
The conclusion is clear: If you’re going to plan your retirement using the traditional asset-based model, then retirement calculators should only be used for scenario analysis, not determining your magic number.
- Use retirement calculators to model a wide range of variables to produce a confidence interval estimating the assets you supposedly need.
- See what happens if you add 10 years of additional income—part-time work, consulting, or whatever might interest you—to take the pressure off savings and allow your assets more time to grow.
- Try modeling real estate rental income that adjusts for inflation and rises when you pay off the mortgage.
- Try modeling what happens when you receive a lump sum inheritance or sell a home or business.
- Try modeling the difference between a conventional asset allocation and a dividend growth portfolio.
- Try modeling if it’s better to delay Social Security or start payments early.
- Try modeling several factors together.
In other words, use the retirement calculator to put numbers behind different life plans for your financial future. Each example will teach another principle just as the examples provided in this chapter and the next chapter teach principles. Retirement planning done right is really about life planning, not calculating magic numbers.
That is how you use retirement calculators properly, and that is why my Ultimate Retirement Calculator is designed specifically to facilitate a simple process for scenario analysis. It allows you to easily model different life scenarios and see how the numbers work.
The Ultimate Retirement Calculator is designed with three specific objectives in mind:
1. It omits meaningless complication and non-essential detail, thus reducing barriers to completing the calculations. It’s more important to plan retirement roughly than not do it at all. It’s also important to not get so caught up in minute details that you deceive yourself into believing the output is scientifically accurate.
2. It provides a simplified platform so you can model various real-life scenarios using all three asset classes (not just paper assets, like competing calculators). No other calculator allows that flexibility that is essential for the way modern retirements are planned.
3. It allows you to quickly and easily build confidence intervals by varying single inputs and seeing how it affects overall output.
In short, this calculator is designed for scenario analysis—not mythical magic numbers—because that’s what is useful when estimating how much money you need to retire using a traditional asset-based approach. The common mistake is to make the process all about asset accumulation when there’s far greater value in the life planning aspect.
Calculators are best used for mapping a path and putting numbers behind your life plan. They’re indispensable for seeing the financial impact of what-if scenarios so you can make better informed decisions about your future.
Scenario analysis is how you blend life planning with retirement calculators to engineer a realistic roadmap for achieving financial security. It’s a practical approach for retirement planning that avoids the myths and traps that have unfortunately become conventional wisdom. It acknowledges the inherent limitations in designing an asset-based retirement plan and provides a practical solution.
Now that you know scenario analysis is the right approach for using retirement calculators, below are 4 rules to help you implement that scenario analysis wisely.
- Walk Forward Process: Don’t perform the retirement savings goal exercise once, put it on a shelf, and then forget it. Instead, check back every few years and see what assumptions proved valid and which ones did not. Adjust your assumptions, recalculate, and shift your plans accordingly. Rinse and repeat every few years. This way you’ll hit your retirement target like a rocket constantly course correcting toward its target.
- Errors Multiply: Small errors in estimates compound into large errors in results. Retirement savings are built and spent over multiple decades. A 2% error in inflation or investment return that is manageable over 5–10 years is a complete disaster when compounded over 30–40 years. That’s why you must regularly recalibrate over time based on actual results. Small details in key numbers cause huge differences, so pay particularly close attention to the key numbers.
- Teach Principles: Retirement calculators are invaluable for teaching essential retirement planning principles. Users quickly grasp how real return net of inflation is the most important number after just a few quick scenario tests. They also see the importance of time in compounding their way to wealth versus saving their way to wealth without the benefit of compound returns over time. They see the erosive effect of inflation by watching how their spending escalates out of control. Without a calculator these concepts are difficult to grasp, but with a calculator they become obvious for even a layman.
- Maintain Flexibility: Avoid calculators that limit your ability to change assumptions. It’s shocking how many calculators pre-program assumptions for investment return, inflation, longevity, and other important inputs. When an assumption is hard-coded into a calculator, it reduces your ability to plan scenarios.
In other words, use retirement calculators to plan, test, and hypothesize your retirement future. They’re extremely useful when properly applied with a clear understanding of their inherent limitations.
It may seem like the task is impossible given the magnitude of potential error, but with enough practice in scenario analysis, you’ll find acceptable workarounds and solutions so you can plan your life in a way that will result in long-term financial security.