Categories: Retirement Planning
      Date: Dec 30, 2010
     Title: Retirement Planning—Too Important to Leave to On-Line Calculators (Part 1)

Why would you pay a financial planner to do retirement projections when you can access a plethora of free retirement calculators on the Web? Or, if you're a DIY guy who is handy with Excel--why not do the projections yourself? Or, for that matter, why not take advantage of that "financial advisor" who has offered to do a "free" retirement plan for you?

Go ahead and use the better calculators, or build your own spreadsheets, just to get a top level view of whether you are saving enough or how much you may be able to spend in retirement. But, when real decisions are on the line that will significantly impact your financial future, make the required investment in time and expertise to get the job done right.

Let's take a quick look at ten areas that make retirement planning and projections too complex to be left to most on-line calculators or your home-grown spreadsheet. Here are the first four, and the remaining six will be discussed in Part 2.

1. Inflation: We all know that a dollar today is likely worth considerably less in purchasing power a few years down the road. Making sure inflation is accounted for in a consistent, accurate fashion, is absolutely critical. How many people make the simple logical error of projecting the value of their portfolio at age 65, but fail to also adequately inflate their anticipated spending requirements? Wouldn't it be a shame to wake up and discover that your million dollar portfolio won't support your lifestyle in 2025? (Maybe you should have saved just a bit more.)

2. Investment rates of return: Retirement calculators usually require you to input an assumed investment rate of return. This is obviously a very important assumption, and it's one where everyone pretty much guesses. Granted, even a trained financial planner doesn't have a crystal ball, but he should be able to approach this in a realistic, analytical fashion. For instance, in assembling the retirement projection a competent planner must (or should):

• Make sure nominal rates of return are consistent with the inflation assumptions, resulting in a reasonable real rate of return assumption. (If this one statement doesn't make complete sense to you, you probably don't want to be doing your own retirement projections.) For example, a 6% nominal rate of return may be reasonable with a 3% inflation rate, resulting in a real rate of return of 3%. However, if you are assuming only 1% inflation, this 6% nominal return may be too optimistic. Coupled with a long term 4.5% inflation assumption, it may be too pessimistic.
• Make sure that the return assumptions are consistent with asset allocation decisions. For instance, a 5% real rate of return assumption may make sense with an asset allocation of close to 100% stocks, but makes no sense with an allocation of mostly bonds. Also, you need to consider how your asset allocation will change over time-generally becoming more conservative as you get older.
• Make sure the impact of investment costs is considered adequately. Even if you had perfect foreknowledge of future market returns, that doesn't mean your portfolio will match it after expenses. If you are using mutual funds with expense ratios that average 0.75% per year and you pay an investment advisor another 0.75% per year, then your assumed rate of return should take this 1.5% cost headwind into account.

3. Sequence of investment returns: Although it is important to have realistic real rate of return assumptions, that alone is not enough. As we are all painfully aware, the markets don't deliver their returns in a consistent fashion. Not only is the average of returns important, but the sequence of returns can have a major impact on how well your investment portfolio holds up over retirement. Retirement projections that simply assume a consistent rate of return over the years are much simpler, but can be dangerously optimistic. For example, if you happen to have the misfortune of starting retirement withdrawals in the midst of a bear market like the one just experienced, your portfolio may very well be depleted long before the simplistic model predicted. More complex calculators and financial planning software use Monte Carlo analysis or historical back-testing to gauge how well portfolios will hold up over different conditions. Planning software or calculators that incorporate Monte Carlo analysis are certainly not perfect, but they are helpful and a big step in the right direction.

4. Income taxes: The impact of taxes on your retirement income over the next few decades cannot be ignored, but is a major computational headache. Investment income, retirement accounts, and Social Security all have different tax rules that will influence how much after-tax income you have available to spend. In what order will your retirement assets be tapped, and how does that impact taxation? Do you assume that tax rates will stay similar to today's, or are you concerned that taxes will likely increase?

Before we move on to the remaining retirement planning considerations in Part 2, it's important to step back a bit from the discussion and clarify some important points:

• Planning for your financial future, including retirement, is a very smart thing.
• There are plenty of free or inexpensive resources to help you get started and do some high level planning.
• The whole exercise of planning for decades ahead is very complex and to do this planning well takes time, effort and expertise.
• Although the planning process is extremely valuable, the resulting plan will be wrong--guaranteed.There are just too many assumptions about an unknowable future.
• The key benefit of planning is identifying the necessary actions, attitudes, and behaviors we can modify today to give us the best chance of achieving the desired outcome tomorrow.

Carl Richards provides a helpful analogy from this post on The New York Times' Buck's Blog:

Think of this as the difference between a flight plan and the actual flight. Flight plans are really just the pilot's best guess about things like the weather. No matter how much time the pilot spends planning, things don't always go according to the plan. In fact, I bet they rarely go just the way the pilot planned. There are just too many variables. So while the plan is important, the key to arriving safely is the pilot's ability to make the small and consistent course corrections. It is about the course corrections, not the plan.

For more on the complexity and the value of retirement planning, see Part 2.