The Big Flaw in Retirement Calculators

Young professionals see such calculators when they log into their 401(k)s telling them how much they need to save to retire on schedule. Baby boomers often crunch numbers on them before riding off into the retirement sunset. I’m talking about the typical retirement calculator. You may have seen one of these before. They all ask for the same basic info: your current age, your desired retirement age, how much you’re saving, what you’d like to spend in retirement, and what flat, fixed rate of return do you want applied to your portfolio over the course of your life. You hit enter and, boom, your financial fate is determined. But how reliable is this?

Well please consider this. Let’s say you picked an 8% rate of return for your portfolio. The calculator will assume you earn 8% every year.   But at the same time, you know that the odds of receiving the same 8% every single year for decades are pretty close to zero.

In response I often hear, “But Scott, that 8% is an average return. I know the market is up some years and down others, but if the returns average 8% per year, this calculator is good enough.” Let me share an example that will illustrate the big flaw inherent in the common retirement calculator.

Please take a look at the top chart on the second page of this document: Why an assumed flat rate of return isn’t enough. This person retired at age 60 in 1967 with a $1,000,000 portfolio intended to cover 30 years of spending. 30% of this portfolio was invested in US stocks and 70% was invested in bonds. This person withdrew $55,000 per year in retirement, adjusted for inflation. Finally, our retiree selected an 8% fixed rate of return per year.

The retirement calculator spit out a result saying our retiree will have money to burn well into their 90s. This calculation is represented by the grey line in the top chart that portrays the portfolio never dipping below $800,000. Furthermore when looking at the years 1967 – 1996, our retiree’s portfolio returned an actual average return of 9.13% per year. Because our retiree assumed an annual average return of only 8%, he or she must surely be financially comfortable! Wrong.

Assuming our retiree stuck to the spending plan, he or she would be broke around age 85, as depicted by the blue line in the top chart. How could this be?! We assumed an 8% annual return in the calculator, and the portfolio actually returned an average of 9.13%. What happened?

The ordering or sequence of up years and down years in the market over this 30 year stretch is the culprit. Please look at the bottom chart on the same page. The fixed 8% assumed annual return is represented by the flat grey line. The blue bars show the actual return the portfolio received in a given year. Subpar returns early in retirement derailed this person’s plan despite the higher than projected average portfolio return over the entire time period.

If one cannot rely on these basic retirement calculators, what can be done? I recommend working with a financial planner who can stress test your portfolio for a wide range of potential returns in various sequences. While no one can predict how the market will behave in the future, stress testing will at least acknowledge that one will most likely not receive the same fixed rate of return every year. Proper stress testing should provide a probability or likelihood of achieving your future financial goals. If you’d like more details or want to discuss further, I welcome you to contact me or schedule a call.

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