Your Retirement Income Calculator Might Be Lying To You

by: Brad McCarthy


It’s About Money, Not Age.

Using A Static Return Estimate Leads To Highly Inaccurate Results.

Single Point Solutions Are Unhelpful.

Social Security And Pensions Need To Be Included.

If You Can Estimate Your Tax Rate, Why Can’t You Use It?

At the age of 46, I decided to quit my electrical engineering job and enter early retirement. Wanting to spend more time with my family, and to follow my own creative interests were my main motivations. In order to quantify my ability to live off my investments, I tried many different types of retirement income calculators. Finding none that fit my needs I decided to develop my own as a mobile app. This article details some of the most important design philosophies I used in this development and why they are improvements over existing calculators.

1. It's About Money, Not Age

First is a subtle argument on retirement related bias. When I retired, what I did was not actually considered retiring. As far as the company I worked for was concerned, I quit. I did not need to register with human resources, or to discuss with them all of the benefits for which I would now be eligible. One reason for this was that I was not the right age as far as they were concerned. Also, they had not promised me a pension that I could receive as a lump sum or an annuity. This sense of not matching up to a pre-determined idea of what a retiree looks like is probably very common among early retirees.

I decided to create an app that anybody could use in order to determine if they were ready for retirement. One of the underlying assertions was that retirement is about money, not age. You can safely consider retiring when you have enough money, no matter what age you are. The problem is your confidence in knowing that you have enough money, and for that you will need a good calculator. A good retirement calculator will ask you to enter "years until retirement" and "years in retirement" instead of various ages (your current age, age at retirement, age at death, etc.). Additionally, it will ask you to enter "years until benefits begin" for both Social Security and pension as necessary (see point 4). If you have enough money to retire at age 35 (including the money to purchase your own health insurance) and pursue your own interests, the fact that you are 35 should not prevent you from doing so. This is a reason why the term "financial independence" is now becoming a widespread synonym for "retirement".

Figure 1 - Using "years to" or "years until" Simplifies Inputs For All Users

2. Using A Static Return Estimate Leads To Highly Inaccurate Results

Most retirement income calculators ask you to enter your expected annual return in retirement, and helpfully suggest you choose something like 9%. While the long-term return of the S&P 500 (NYSEARCA:SPY) is around 9% annually, adjusting for inflation it is closer to 6.5% annually. Using either of these numbers as the expected annual return of the equity portion of your retirement portfolio will lead to inaccurate results. Just look at stock returns over the last decade and a half. For the years 2000-2015 the annual S&P 500 returns (including dividends, not inflation corrected) were; -9.1%, -11.89%, -22.1%, 28.68%, 10.88%, 4.91%, 15.79%, 5.49%, -37%, 26.46%, 15.06%, 2.11%, 16%, 32.39%, 13.69%, and 1.38%. The volatility of stocks during your retirement could ruin your retirement, or ensure its success. A few bad years at the beginning of your retirement and you might run out of money sooner than you expect.

The static return estimate is just not useful for someone planning an actual retirement. Your money will not sit untouched for 100+ years so that you might have earned an average 6.5% real return annually, while assuming the stock market behaves the same in the future as it did in the past. You will be taking money out each year to fund your retirement which will directly impact whether you end up running out of money during retirement or not. What you can count on is a high level of volatility in annual returns ranging from large losses to large gains. This cannot be modeled correctly for a 30 or 40-year retirement by estimating a static annual return. The same goes for bonds. The bond portion of your retirement portfolio will be less volatile than stocks (assuming that bond indexes (NYSEARCA:AGG) behave similarly in the future as they have in the past), but assuming a static annual return will still be highly incorrect.

A retirement income calculator that uses randomly selected, real (inflation adjusted) annual returns from stock and bond indexes can be used to better predict future returns. This will allow the calculator to estimate future returns while capturing the volatility of the indexes. Also, a future expected annual inflation rate during retirement would need to be implemented in order to determine how your annual retirement income will need to grow each year.

Figure 2 - Annual Income Will Grow Each Subsequent Year By Inflation Rate

3. Single Point Solutions Are Unhelpful

Most retirement income calculators provide you with a single result, and happily tell you if you are ready for retirement or not. Even if a calculator uses randomly selected prior year index returns for future expected returns, this is not helpful. A good calculator will simulate many different complete retirement outcomes in order to provide a statistically significant result. This is a perfect use of the Monte Carlo simulation.

A retirement income calculator using a Monte Carlo simulation will be able to randomly select expected annual returns each year in a complete retirement scenario, then perform many more iterations of complete retirement scenarios using different randomly selected expected annual returns. If the calculator divides the retirement scenarios that ended with a balance greater than or equal to 0 to the total number of scenarios, it can provide a success probability of meeting your retirement income goals. You will know that the Monte Carlo simulation has captured most of the possible scenarios if you can run it multiple times without seeing the result change by more than a few tenths of a percent. This method will provide confidence that you are capturing best-case scenarios, worst-case scenarios, and most of the cases in between.

Figure 3 - Number Of Monte Carlo Iterations Used And Simulation Results

4. Social Security And Pensions Need To Be Included

The Social Security Administration's basic fact sheet states that, "Social Security benefits represent about 39% of the income of the elderly." To provide useful information, a retirement income calculator must include estimated Social Security benefits, but many do not. Social Security benefits can be estimated by using the tools available on the Social Security Administration website. Most retirement income calculators do not have the ability to factor in pension benefits either. Regarding pensions, the Social Security basic fact sheet also states that, "51% of the workforce has no private pension coverage." If 49% of workers have some form of private pension, the ability to include pensions in a retirement income calculation is important.

Figure 4 - Including Social Security And Pension Improves Accuracy And Success Probability

5. If You Can Estimate Your Tax Rate, Why Can't You Use It?

Most retirement income calculators will not allow you to factor in the effects of taxes. A calculator should ask you how much money you will take out of your retirement portfolio each year (your annual retirement income). If you just want to perform the simulation by incorporating how much money you will take out of your retirement account each year (before tax money) you should be able to do that. If you would rather perform the simulation by estimating your personal expected tax rate you should be able to do that too.

You might want to develop your own conservative budget of your expected expenses and use that for your annual retirement income. If an estimated tax rate is chosen, the calculator should increase the annual retirement income during the simulation to account for taxes (i.e. annual retirement income / [1 - [tax rate/100]]). The annual retirement income will then be considered after tax income (and should be increased by the inflation rate each subsequent year of the simulation). One reason for wanting to calculate the effects of taxes on your retirement income success probability is that many retirees will have income from sources with different tax treatments (401(k), Roth IRA, Social Security, pension, brokerage account, etc.). You alone will be able to estimate your expected tax rate, and a good calculator will allow you to enter that rate.

Figure 5 - Tax Rate Of 0% Means Income Is Before Tax, Any Other Tax Rate Means Income Is After Tax

6. Other Considerations

Some of the other important considerations include; the ability to perform simple sensitivity analyses, and save results for future inspection. A good calculator should be able to allow the user to quickly adjust inputs and re-run the simulation to see how the success probability is impacted. For example, you should be able to experiment with changing the mix of stocks and bonds to see how that might impact success. You should also be able to save the simulation results with all of the inputs that were used, in order to re-run the simulation at a later date and expect the same results.

Figure 6 - Change Inputs And Quickly Re-Run Simulation For A Quick Sensitivity Analysis, And Capture Full Resolution Simulation Results Including All Inputs


Most retirement income calculators fall far short in terms of; ease of use, inclusion of all necessary inputs, tailoring the inputs to your specific circumstances, and in providing a statistically significant result. In addition, many people are concerned (rightly so) with providing detailed personal information on a random website after searching for a retirement income calculator online. Before retiring (at any age) you should perform your due diligence to determine if you are financially ready. A good retirement income calculator can be an important tool to use throughout your working years, to help you make that decision. Used weekly, or as your circumstances change, it can help focus your attention on what changes you can make to improve your retirement income success probability.

Disclosure: I am/we are long SPY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am trained as an engineer, and am not a financial professional. This article reflects my own opinions and should not be considered financial advice.