Posted by: drdata921 | July 5, 2013

Retirement Financial Calculators: A Guided Tour of the Black Box

So, you have done your due diligence to assess your retirement financial situation. You have been on-line to understand your sources of retirement income. You have made an attempt to calculate your expenses and you have some vague idea of what you savings will be when you retire. Now what?

While there is no shortage of articles and books written on the topic of retirement financial planning, it is still very difficult to put all of the pieces together. Even when you have collected all of the pertinent information, the final answer is still unclear. What to do?

Behold, the retirement financial calculator. These calculators vary in their sophistication and the level of information they provide. However, their single focus is to answer questions about your retirement financial security. Among the questions are:

– How long will your savings last.

– What are the annual spending limits based on you income, expenses, and savings?

– What if inflation is more or less than you expect.

– What if the investment returns on your savings are more or less than you anticipate.

Some financial calculators are more comprehensive than others, but the general focus is to try to anticipate your situation in retirement. In their most basic form, financial calculators are mathematical computer programs that link the basic factors related to your financial success with information specific to your situation.

THE BASIC FACTORS AND THEIR LINKAGES

So, what goes on in the bowels of the typical retirement financial calculator? First, all of the factors that you have read about relative to retirement finances affect each other is some very complex ways. Let’s take a look these factors and how they interrelate:

RETIREMENT INCOME is derived from sources such as Social Security, Pensions, and post-retirement employment.

RETIREMENT EXPENSES are what you spend to maintain your standard-of-living.

HOW THEY INTERRELATE: If income is greater than expenses then you are good to go, at least in the shortterm. However if expenses are greater than income, then you have a shortfall. Retirement savings are one resource you have to cover this shortfall. The question is how long savings will be available to do this.

Income, expenses, and estimated savings are all basic inputs into most financial calculators. If this was all you had to worry about, it would be simple. In a simple world, let’s say that you have saved $500,000 for retirement and your annual shortfall is $20,000. In this case your savings should last for 25 years ($500,000 savings/$20,000 shortfall each year = 25 years). If only it were that simple. In addition to income, expenses, and savings, you have two other things that you need to consider:

INFLATION is the increase in the cost each year required to maintain your standard-of-living. Inflation whittles away at that 25 years. Inflation raises expenses and can make the shortfall greater, lessening how long your savings will last. You do have some help on the income side since Social Security is adjusted for increases in inflation each year, but generally inflation is a losing battle.

However, on the positive side, inflation is counterbalanced by one other factor:

SAVINGS INVESTMENT RETURNS. Unless you draw out all of your savings when you retire and stuff it into a mattress, you should be earning returns on your savings investments. So, while investment returns giveth, inflation taketh away! The question is how they offset each other.

Notice how complex this becomes. The purpose of a retirement financial calculator is to program these complex relationships among the various factors, take you specific information, and provide you with an assessment of how long you will be financially secure.

WHAT ARE THE ODDS

To invoke a line from a popular sales pitch, “but wait, there’s more.” While income and expenses are relatively predictable, inflation and investment returns can be volatile. So, if you are trying to predict your financial situation for a 20 or 30 year retirement and you are not sure about two key variables then what?

To deal with this some financial calculators use a statistical methodology know as Monte Carlo. I won’t get into a technical discussion of Monte Carlo. However, this technical add-on, which is included in some financial calculators, changes everything. Rather, than asking the question of how long you savings will last, which will vary with inflation and investment returns (two huge unknowns), it changes the question to “what is the probability that your savings will last for various time periods. For example, what’s the probability that they will last for 15 years, for 24 years, etc. Monte Carlo uses the uncertainty created by the volatility in inflation and investment returns to calculate these probabilities.

THE UNKNOWNS ARE WHAT DRIVES YOU CRAZY

Even with the help of Monte Carlo, there is still one huge unknown that is at the crux of the retirement financial question: How long do these resources need to last (i.e. how long will you live). What a typical retirement financial calculator will do is estimate how long your funds will last. You will need to guess whether that will be adequate given your expected lifespan. So, the net of this is use retirement financial calculators for general guidance, but understand that there are limitations to what these tools can provide.

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Responses

  1. […] as well as the financial requirements, as detailed in several posts including this one:       https://journeyintoretirement.com/2013/07/05/retirement-financial-calculators-a-guided-tour-of-the-…    He’s written a book on this element of the planning process and is very interested in […]


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