At its heart, the idea of planning for retirement is very straightforward. Like squirrels in the autumn, hopeful future retirees stash away some of the nuts they gather each day so they’ll be able to eat when the gathering season is past. Unfortunately, the problem is more complicated for us humans. Squirrels only need their stash to last for a few cold months of winter, while retirees depend on their stash for thirty, forty, or even fifty years. This difference can make the problem seem overwhelming, and can leave people frozen with indecision.
To make matters worse, we’re inundated with conflicting advice about how we should invest our savings to best accomplish our retirement goals. Should we hire an investment advisor? Should we use index funds or actively managed funds? What funds should we buy? How do we build the very best portfolio to get the highest returns?
While these questions are valid, they become inconsequential if the apprehension they produce causes us to do nothing. What matters most is whether we save enough money for a long enough period of time and whether we make reasonably good investment choices. Notice I said reasonably good investment choices. Too many people feel that successful financial planning is about scoring frequent Jim Cramer style “booya” home-runs on brilliant stock picks. The facts just don’t support this oft repeated lore. What really matters is that you develop a solid plan and stick with it.
When can I get off the treadmill?
To determine how much you need to retire, you must first decide how much you want to spend in retirement. What standard of living do you desire in retirement and how much will it cost to fund that lifestyle? This is by far the most important question in retirement planning.
Fundamentally, this is a question about trade-offs. How much should we sacrifice during our working years, and for how long, so we can be happy during those golden retirement years. The tradeoffs get even more complicated when you consider other competing factors such as children’s education, the care of elderly parents, and concerns about one’s own health. Once again, it’s easy to get bogged down in the complexity of it all, but like any decision involving trade-offs, it becomes much simpler if we can understand what the costs and benefits of our various options are.
This is where a retirement planning tool can help. A retirement calculator can help you experiment with different levels of savings, different retirement ages, and different levels of retirement spending. By using a retirement calculator to run retirement “experiments”, you’ll be able to see the costs and benefits of choosing among the various paths. Retirement planning is deeply personal, and only you can decide what trade-offs make sense for you and your family.
I’m ready to calculate. Now what?
Retirement calculators can provide you with information to help you make choices about various retirement options. But remember, these tools are not “smart” and they can’t weigh the options for you. Their role is to assist you by arming you with the information you need to make good choices.
Most retirement planning tools ask you to provide information about expected savings, desired retirement age, and the annual expenses you plan to incur during retirement. The tools use this information, along with assumptions about inflation, taxes, and portfolio performance, to estimate the likelihood that you’ll be able to fund your expenses for the duration of your retirement.
This likelihood of success is the tool’s way of indicating how solid of a plan you’ve constructed. If the likelihood (or probability) of success is low, say below 50%, then you have a less than 50/50 chance of having enough money in retirement. On the other hand, if the probability of success is above 90%, then your plan has a very high likelihood of being able to provide income you’re seeking during retirement.
Wait a minute you say, I simply want to know if my plan works. Why can’t the tool just tell me that?
Most advanced retirement planning tools use the concept of probability to report their results. This is because most tools work by running thousands “simulations” of your retirement. In each of these simulation runs, the software plugs through all of the calculations of your retirement year-by-year to see what happens. In the runs where the simulation reaches the end of the plan and still has money to spare, the run is called a success. Runs where the money is gone before the end of the plan are called failures. The ratio of successes over failures is your plan’s overall probability of success.
Still you say, why does the planner need to make thousands of simulation runs? Why doesn’t it just do it right the first time and give me the right answer? Well, it turns out that long-range planning, such as retirement planning is not an exact science. No one knows for sure how investments are likely to perform in the future, so the best anyone can do is try to make estimates of the future. The problem with making an estimate is that it could be wrong. So instead of making just one estimate, several thousand estimates are made. Most planners do this by considering how investments have performed in the past and then using this information to make guesses at what might happen in the future as your retirement plan unfolds. They do this over and over again and record the results of each “run”. Then they summarize the results by showing the overall probability of success for the plan.
Ok, I got it, let’s start simulating my retirement
Once you have a basic understanding of what a retirement planning tool does and how to interpret its output, you’re well on the way to being able to make use of this powerful helper. Although there are several good tools in this space, for the rest of this article, we’re going to focus on one particular tool that’s freely available on the Internet and runs inside your web browser.
The tool is called the flexibleRetirementPlanner. I created this tool for myself as I was evaluating my own retirement plan. I found that the other tools out there were either too simple, or didn’t shed enough light on how they worked for me to trust them. For this reason, I also published the source-code of this tool (see the website) so anyone can look at how the planner really computes its results. You’ll be glad to know that the tool is free to use and you don’t need to sign up for anything or give out any personal information to use it. Also, all the information that you enter into the planner stays on your own computer and nothing is transmitted back out onto the Internet, so you can be sure your information will stay private.
Follow the steps below to set up the retirement planner to evaluate your retirement plan’s chances for success.
1) Current Age – Enter your current age
2) Retirement Age – Enter your planned retirement age. This is the age when contributions will stop and you’ll begin withdrawing from your savings.
3) For now, leave the Life Expectancy, Inflation, and Tax rate info at their default values.
4) Current Taxable Investments – Enter the current total value of all invested assets that are NOT in a retirement account.
5) Current Tax Deferred Investments – Enter the current total value of all tax deferred investment accounts such as those in 401k or IRA accounts.
6) Current Tax Free Investments – Enter the total value of all tax free investment accounts such as Roth IRAs or Roth 401ks.
7) Leave the Min IRA Withdrawal age at its default value
The next three fields are where you enter your expected annual savings. If you’re not sure what to put here, start out by entering 15% of your annual household income in the “Tax Deferred Annual Savings” field. You can tweak this later. Also, please note that like most other values used in the calculator, the amounts you enter for annual retirement savings are automatically increased each year to keep up with inflation.
8) Taxable Annual Savings – Enter the amount that you plan to save each year in taxable accounts (not IRAs or 401ks).
9) Tax Deferred Annual Savings – Enter the amount that you plan to save each year in traditional IRAs and 401k accounts.
10) Tax Free Annual Savings – Enter the amount that you plan to save each year in Roth IRAs and Roth 401ks
11) Investing Style – Leave this input at its default value for now. Later you might want to experiment with other values for this field. After you’re done evaluating your plan, the next step will be to learn about investing to see how you can create an investment portfolio that will help you meet the goals of your plan.
12) Annual Retirement Income – Enter the amount of income you expect to receive each year while you’re retired. This should include social security and any pension income that you expect to receive. Please note that the value you enter in this field is assumed to increase each year to keep up with inflation. If you have a pension with fixed payments, use the “additional inputs” tab to enter it as a pension with “no cola” or no cost of living adjustment.
13) Retirement Income Start Age – Enter the age you expect to start receiving the income amount that you entered in item 12 above.
14) Annual Retirement Spending – Enter an estimate of how much you plan to spend in each year of your retirement. The amount you enter should be in today’s dollars. It will be automatically adjusted each year to keep up with inflation. If you don’t have any idea of what to put here, some suggest using 85% of your pre-retirement spending as a rough guide. This is one input that deserves a lot of thought in order to make as realistic of a guess as possible.
15) Spending Policy – Leave this value at its default setting for now. After you’ve experimented with the planner for a while, you may want to read the planner documentation about spending policies to learn more about what this means.
Alright already, now I’m really ready. Show me the money!
Once you’ve completed the steps above, you’re ready to run the planner. Click on the “Run Simulation” button and the software will run through your retirement 10,000 times to estimate the likelihood that you’ll have enough money to fund your retirement.
Once the computations are complete, the first thing to notice is the “Probability of Success”. If this value is above 90%, a green light is shown next to the value. If you’ve estimated all the inputs correctly and your plan has a probability of success greater than 90%, your plan is in great shape. If your probability of success is between 75% and 90%, the stoplight will show yellow. This is also a good probability of success, though this also means that your plan may have a 10-25% chance of failing. Finally, if your plan’s probability of success is less than 75%, that means you have at least a one in four chance of running out of money during your retirement.
Next, you may want to look at some of the other simulation outputs to further evaluate your plan. The ending portfolio balance shows how much money (in today’s dollars) you’ll have in savings at the end of your plan. Finally, you can select the “Detailed Output” tab to see the year-by-year information for your plan.
Once you get an idea of how to run the planner and how to interpret the results, you can try different scenarios to see what the results are. For example, try increasing your annual savings a bit to see how that affects your plan’s chances for success. Also, if you have a very high probability of success, try decreasing your retirement age little-by-little to see how that affects the results. The possibilities for experimentation are endless, but don’t get discouraged by this. You’re in command of the decision-making process, and now you’re armed with a tool that can help you make better choices.
After experimenting with the planner for a while, you should start to feel more in control of your personal retirement destiny. You’ll have a better understanding of the trade-offs in front of you, and you should be in a better position to make good choices about how much to save and how long you’ll need to keep working. If you’re new to financial planning and investing, this is a great time to dive in and learn more. Just don’t delay. The one thing this adventure in retirement planning should have shown you is that time is your most precious resource.