Get Rich Slowly recently hosted a post from Motley Fool writer Robert Brokamp about how much money it takes to retire. The article links to the Motley Fool’s “Am I Saving Enough?” calculator, which seeks to answer the question of how long you can expect your retirement savings to last.
I’ve written before about why I don’t trust retirement planning calculators, and this one is a perfect example. Go ahead and take a look at it.
Among other things, it asks you:
- How much you have saved now and how much you’re saving per month,
- What portion of your savings are in which type of accounts (401k, Roth IRA, taxable, etc.),
- How much you expect to spend each year in retirement (and it allows you to provide a good deal of detail for how you expect that figure to change over time),
- Your current tax bracket as well as your projected retirement tax bracket,
- How much you expect to receive from social security or a pension, at what age you expect to begin receiving such income, and whether or not that income is adjusted for inflation,
- How old you are now, at what age you expect to retire, and what age you expect to live to.
You get the idea. It asks for much more information than most retirement calculators. This is a good thing, as it allows for greater precision.
But It’s Still Worthless.
Unfortunately, the answer the calculator gives you is complete garbage.
The reason — and I bet you saw this coming — is that the calculator uses unrealistic assumptions for its calculations. Specifically, it asks you to enter a given rate of return, and it then assumes that your portfolio earns that same return every single year.
Let’s Be Realistic.
In real life, returns vary from year to year — even if you stick with extremely low-risk investments. A calculator that assumes a constant return every single year is going to significantly understate the amount you need saved before you can retire safely.
Said differently, if you expect your portfolio to average a certain rate of return over the course of your retirement, you probably need to set your starting withdrawal rate below that expected return figure unless you want to face a meaningful risk of running out of money.
For example, if you expect your portfolio to average a 6% return throughout your retirement, withdrawing 6% of your portfolio in the first year and increasing the amount withdrawn each year to keep up with inflation would be setting yourself up for trouble.
The reason such a strategy is risky is that a high withdrawal rate is absolutely devastating to your portfolio if you happen to face a prolonged bear market early in retirement. After a few years of “selling low,” you’re left with too small a portfolio to benefit fully when the market does come back.
This poorly-timed-bear-market concept is known in finance as “sequence of returns risk.” Ignoring it completely — as the Motley Fool calculator does — will cause you to significantly underestimate the amount of savings you’ll need in order to retire.
- Don’t trust a retirement calculator unless you can see all of its assumptions and you judge them to be reasonable. One poor assumption can make an otherwise-great calculator worthless.
- Don’t overlook sequence of returns risk when planning for your retirement.
And just for fun, here’s a screenshot taken when I plugged in a 6% withdrawal rate and a 6% rate of return.