You don’t need me to tell you that saving for retirement is important. You’re the kind of fiscally responsible person who uses Mint and procrastinates from work by reading personal finance columns.
So you go out into the wilds of the web and fill out a retirement calculator to see how much you should be saving. The calculator spits out an answer, and you and your 401(k) live happily ever after.
Well, I went out onto the internet to play with retirement calculators. (“Good times” is my middle name.)
Here’s what I found: every retirement calculator makes its own assumptions about your salary growth, inflation, and Social Security.
Most important, they all make an assumption about the performance of your investments.
Or, worse, they ask you to enter your own assumption. Will you earn 3%? 5%? 7%? 10%?
Where’s the “who the heck knows?” button?
The rate-of-return assumption is important, because we all know about the power of compound interest.
A seemingly insignificant difference in your investment growth rate can mean the difference between peanuts and caviar in retirement.
The real deal
Before we talk about investment performance, we need to consider inflation.
The right way to think about your retirement is in today’s dollars.
It doesn’t matter if you have a $1 million balance in your retirement account in thirty years; what matters is how much stuff you can buy with the money.
Why today’s dollars rather than future dollars? Because you already have an intuitive sense of how today’s dollars spend.
So when you think about the rate of return on your investments, you need to think about it in real (post-inflation) terms. If you earn 7% this year but inflation runs 2.5%, your real return is 4.5%.
The 7% figure sounds impressive, but it’s a mirage. Any time you hear about 8% (or 10%, or 12%) returns, ignore it.
After inflation, that level of investment performance over the long run is extremely unlikely—and certainly not worth counting on as part of your retirement plan.
I tested six retirement calculators from well-known companies. If they asked me to estimate my rate of return, I just went with their default or suggestion.
The suggested real rates of return ranged from 3% to 5%. This doesn’t sound like a broad range. So I did a simulation.
Say I start saving today and put $1000/month into my retirement account for the next 30 years. On the big day, how much do I end up with?
Let’s have a look:
|Rate of return||Final balance|
That’s a quarter-million-dollar range.
It’s almost like these calculators, provided by some of the most respected investment companies in the world, have no flipping idea how much your investments will earn.
The most respected investment companies have no idea how much your investments will earn
Let’s think back on the last 30 years. We had a massive economic boom, leg warmers, Black Monday, flannels, the dot-com bubble, 9/11, Facebook, the housing bust and financial crisis, and hipster beards.
Would you have predicted any of this stuff in 1983? Or any of the thousand other events, crises, and trends that affected your savings, directly or otherwise?
Those data points suggest we shouldn’t be too optimistic about the next ten years of investment returns. But the market doesn’t have to listen to our prognostications.
What does that mean for us, folks who are just hoping to retire someday? It means that no retirement calculator is going to give us a number that will turn out to have been correct in retrospect.
People love concrete numbers, and if what it takes to get you saving is a retirement calculator that tells you to save $971 a month, so be it.
Barring an apocalyptic scenario, all we can really say is (get ready for this, because it’s earth-shaking):
On average, people who save will be better off than people who don’t.
Give the future its share
The other problem with retirement calculators is that they assume you make a regular, predictable salary that allows for regular, predictable retirement contributions.
I don’t, and neither do a lot of the artists, musicians, web developers, contractors, and bloggers I hang out with.
People like us are better off approaching retirement savings as a percentage of our paycheck.
An online retirement calculator could do a lot worse than simply asking you how much you made this month and multiplying it by 15%. A little behind on retirement savings? Make it 20%.
Is that too pessimistic a savings rate? I don’t think so. But suppose it is.
Suppose we have an outrageous three decades of exuberant stock market performance, starting today, and you could have gotten away with saving 6% instead of 15%.
That’s not exactly a tragedy in any case. But think of it this way: the market doesn’t warn you about bad times ahead, but it has a foolproof indicator of good times in the past: your account balance.
If all goes well, you can always save less later.