By Justin Pritchard, CFP®
Financial planning is part art and part science. First, you need to understand what’s important to you personally and imagine what you want your future to look like—that’s the “art.” Then, it’s time to do retirement planning calculations to see where you stand.
The value is in the process: Most people think that using a calculator or financial planning software is the most important part of retirement planning. To be sure, the math is critical, but the real value of planning is the entire process:
- You gain a lot personally by clearly defining what you want the future to look like. No matter what your results look like, imagining your future and setting one or two goals can be valuable.
- When you take inventory of your assets and retirement income sources, you learn a lot about your past, current, and future finances. With that knowledge, you can make better decisions.
- Planning gives you a greater sense of control over your finances and your life, which gets you invested in the process.
Emotional topics: Calculating your retirement income can be emotionally challenging.
- Not the answer you were looking for? If you’re like many, you may find that your ideal retirement is not within easy reach. But there are ways to improve your situation, and we’ll discuss those strategies later.
- Mortality: You need to consider topics like your mortality as well as the death or survivorship of loved ones (but you’ll also focus on more pleasant topics)
Retirement Planning Assumptions
Because you’re making calculations about an uncertain future, you need to make some assumptions. For example:
- Investment earnings: How much will you earn on your investments over time, and how do your returns vary year-to-year? Does the rate of return change after you retire?
- Inflation: Prices have historically risen over time. Does your plan account for that, and at what rate? Will your salary and retirement contributions increase each year? Will Social Security or pension payments keep up with inflation?
- Surprises: What “spending shocks” might you face in retirement (or on the way there)? Healthcare events and other significant expenses can put a dent in your retirement assets, and it’s best to be able to absorb a few surprises without getting derailed.
Know your assumptions: In some cases, you get to choose exactly which assumptions go into your plan—you can customize your retirement calculator and other financial planning tools. In other cases, you just use the assumptions built into the software available to you. Either way, you need to know what the numbers are, and whether or not those are reasonable assumptions.
Aggressive or Conservative?
To some degree, you can typically choose how aggressive to make your plan. If you prefer to be conservative, you might assume lower investment returns, higher inflation, and a significant healthcare expense early in retirement.
Being aggressive (or optimistic, if you prefer) makes retirement calculations look better. You can retire earlier, and with a higher income. But if things don’t work out the way you projected, you’ll need to make sacrifices. That might mean temporary belt-tightening after market crashes, or it might mean revamping your plan altogether and working longer.
Conservative planners can enjoy more certainty when they retire, but they run the risk of saving too much (which is hard to do) and working for too long. You may put off retirement for a few years to save more money than you need, but if security is valuable to you and you hate surprises, that may be a small price to pay.
Be flexible. Possibly the best advice is to expect changes to your plan over time. If you’re willing to make some mid-course changes—whether temporary or permanent—you can often avoid disaster.
Retirement planning calculators can help you understand the primary risk of retirement spending: running out of money before you die. For example, a Monte Carlo simulation can run thousands of simulations and provide a “probability of success,” and you get to decide how high is high enough. So if you’re aggressive with your numbers and you only have a 70 percent chance of success, there’s a decent chance that you’ll need to make changes in retirement. Of course, even with a 95 percent probability of success, that 5 percent risk still exists.
What Assumptions Should You Use?
Assumptions are possibly the most important pieces of information that go into a calculator. Unfortunately, there’s no way to know how the future will unfold, so it’s wise to run your calculations using several different sets of assumptions.
Longevity: Plan for a long life, unless you have good information to the contrary. The Social Security Administration notes that “About one out of every four 65-year-olds today will live past age 90, and one out of 10 will live past age 95.” If you’re younger than 65, there’s a good chance that life spans will only increase with medical advances.
Social Security benefits: Speaking of Social Security, will it even be there when you retire? Benefits might disappear entirely, but the Administration could also just reduce your benefits or make up for anticipated shortfalls in other ways (by raising taxes or using a less-generous inflation index, among many other things). With the information we have today, I prefer to reduce benefits moderately, with the amount depending on how many years remain until retirement age.
Inflation: You need an income that increases to keep up with rising prices. But how much is enough? In recent years, inflation has been in the low single digits. But inflation has been anywhere between negative and infinity. The highest rates that people alive today remember (for the U.S., at least) might be a 13.5 percent increase in the Consumer Price Index (CPI) in 1980. In your lifetime, it could be higher or lower than that. It would be nice to think we have things together enough to avoid runaway inflation, but anything is possible, especially over the decades before and during retirement.
Investment returns: Depending on your timeframe, investment returns can make or break your retirement. Look up long-term returns for the investment mix that you currently use, and be sure to note periods of especially lousy performance. If you’re coming up with high numbers, remember that aggressive investors need to be willing to ride out losses of 20-40 percent (or more) and have the patience—and financial ability—to wait years for recovery. Less aggressive investors would be wise to assume lower returns.
- For specific predictions on investment returns, look up “long-term capital market assumptions.” Investment firms typically publish their expectations, and those are educated guesses about what strategists expect in the next 5, 10, or more years.
Again, if you choose to be aggressive, remember that things might not work out as planned. What’s more, the markets don’t move in a flat line, and the sequence of returns may be much more important than the annual average return you earn. Finally, it’s critical to adjust your expectations for any fees you pay on investments.
Run the Numbers
Once you have the information and assumptions you need, it’s time to crunch some numbers. Several retirement calculators can help you do the job. Find one that you enjoy working with, or ask me for suggestions on decent free online calculators.
If you’d like help from a professional, speak with a Certified Financial Planner (or CFP® practitioner), who can help you make a plan and take action. Planners (like me) may be willing to just help you with retirement planning calculations—without requiring you to transfer investment assets or pay commissions. A professional can also validate the estimates you make on your own, providing a second opinion.
Use the Information
Once you get the answers you need, it’s time to either make changes or maintain your plan.
If things look great and you’re on track to meet your goals, congratulations! Revisit your plan periodically to verify that all is well and to reevaluate your assumptions as the world changes. As you near retirement, an annual review is probably wise. If retirement is 15 or more years away, you can probably check in on your plan every few years.
If you’re coming up short, don’t lose hope. Several strategies can help improve your chances of success. It doesn’t take much imagination to see which numbers need to change (retirement age, the amount you save each year, etc.), but simply updating one or two values on a retirement calculator can be depressing. By combining several strategies, you can take less-drastic measures to improve your situation, and we’ll describe that approach another time.