Depending on where you are in retirement planning, the accuracy of the software you are using may not be a great concern, yet. Initially, your use of these tools will be more about your trajectory than your end point. In early career, you mostly need to know if your money moves are taking you in the right direction, and roughly when you might arrive at financial independence.
But, for near-retirees and post-retirees, accuracy in retirement modeling gets much more important….
For a major life decision like retirement, you can’t afford for your calculator to be off by hundreds of thousands of dollars. And, I’ve seen, first hand, over and over again, that this can happen easily with retirement calculator output. I routinely see 30% to 100% variations in calculator results. And even larger errors are not uncommon.
Those variations could represent years of extra, unnecessary work. Or, they might mean running out of money before you run out of life. Either kind of error is extremely serious for your future.
What are the key factors working against retirement calculator accuracy? We can identify three challenges: (1) design limitations and errors in the calculators themselves, (2) inherent difficulties in predicting future variables such as investment returns, inflation rates, and life expectancy, and (3) user misunderstanding and errors.
I’ve covered difficulties in predicting future variables and user errors in other articles on the blog. In this article, I’d like to focus on how the calculators themselves can be designed and implemented for better accuracy.
My interest and knowledge in this area has grown dramatically thanks to Stuart Matthews of Pralana Consulting, one of the leading experts on retirement modeling. He first approached me in the fall of 2013 with his vision for higher-fidelity retirement calculations. (By fidelity we are referring to how well each calculator can potentially reproduce reality — the realism of its simulation.)
Says Matthews: “Errors matter and they do compound just as interest does, and this can make a very substantial difference in long term projections. Low-fidelity calculators can lead to significant avoidable errors. It is possible to build high-fidelity tools that avoid the avoidable and restrict the uncertainty to the areas where it is truly unknown, such as inflation, market performance and life expectancy. And the very best tools acknowledge the uncertainty and present a range of possible outcomes based on what we do and what we do not know.”
We agree that the future cannot be predicted accurately. But overly simplifying your attempts to model it can result in clearly misleading outputs and wrong conclusions. What follows are some of the most important calculator features we’ve identified to avoid errors and deliver the most accurate possible retirement planning results. If you’re a potential or current retiree, beware that your chosen financial planning tool includes all of these features, at least if you intend to make major life decisions based on its output!
Realistic Cash Flow
Let’s start with the essence of financial modeling: Money comes in as income. Money goes out as expenses. Some amounts change over time. Expenses and income generally increase, until retirement, but not always. Taxes take a bite. Low-fidelity retirement calculators oversimplify these details. High-fidelity calculators provide full resolution during both the accumulation (pre-retirement) and distribution (post-retirement) phases.
Consider your earned income. Do you enter gross or net into the calculator? A rough number is fine for rough results. But for accuracy, a high-fidelity retirement calculator will take a gross number from you and compute payroll taxes for Social Security and Medicare, whether you’re an employee or self-employed. The calculator will also handle income tax withholding and contributions to retirement accounts, plus any company matching.
Some low-fidelity calculators ignore separate expenses and income, simply assuming that what is left over, your retirement savings, is all that matters. But this is a crude approach, awkward and inaccurate for modeling real lives over time. And it’s wholly inadequate for the distribution phase, when it’s necessary to have an accurate assessment of your expenses in order to model retirement withdrawals. Calculators that want to assume your retirement income requirements are simply a percent of your working income are laughably inadequate in the real world, highly unlikely to deliver accurate answers for your individual situation.
Finally, when it comes to retirement income, an accurate retirement calculator must allow for precise input of the most common source for most people: Social Security. Your starting ages for Social Security can currently vary within a span of 8 years (ages 62-70) for each partner, with large implications for lifetime income. There are no general rules of thumb, and no substitutes for accurate calculations. Calculators need to handle any legitimate start age for Social Security and adjust, or allow you to adjust, the benefits accordingly.
Separate Account Types
In the modern world, most of us keep our savings in accounts at various financial institutions, not stuffed in mattresses, or buried in treasure chests. But not all accounts are created equal: For starters, there are three primary types based on their treatment at tax time: taxable accounts, tax-deferred accounts, and tax-free accounts.
As the name implies, the growth and income from taxable accounts are taxed, though often at different rates: Interest and dividend income are taxed at your income tax rate, but qualified dividends and long-term capital gains are usually taxed at lower rates. Once taxed, those amounts become part of the “basis” in your account, which a high-fidelity calculator will track.
The withdrawals from tax-deferred accounts are taxed at your prevailing rate for income. Tax-free accounts are exactly that: never taxed.
A high-fidelity calculator will compute tax liabilities for all three types of accounts precisely: There is no guesswork involved in these calculations, just a lot of number crunching. Lower-fidelity calculators usually can’t tax accounts differently, and rarely if ever track capital gains, though these distinctions could be important to your bottom line.
Matthews has studied differences in final savings balance as a function of how your initial balance is split between tax-deferred, tax-free, and taxable savings accounts. He found significant differences in final account balances depending on whether the calculator uses separate account types, or simply treats them as a common pool of money: He found up to an 18% variation, depending upon how the money is split between the various types of accounts at the start of retirement. He’s also looked at the extent to which the growth of taxable savings is due to simple interest or capital gains: He saw up to a 19% variation, depending on whether the growth of regular savings is one or the other.
All three account types grow over time, but how? That’s dictated by the types of assets they hold: cash, bonds, stocks, real estate, and other more exotic asset classes. The exact mixture of those assets is defined by an asset allocation. High-fidelity calculators will allow you define the types and quantities of assets held in each of your accounts, along with their returns in at least four categories—interest, dividend, realized gain, and unrealized gain—for accurate modeling of growth.
To get money out of your accounts to cover retirement living expenses, you must make withdrawals. In the world of retirement modeling, this is much more complicated than inserting your debit card in an ATM.
In retirement, you aren’t simply consuming a paycheck that comes into a single account. Instead, as we’ve discussed, you are generally living off savings from a collection of accounts. So, you must regularly choose the source of your funds. And, as cash runs low, you must choose which investment(s) to liquidate.
High-fidelity retirement calculators let you specify the withdrawal order for your accounts: Which assets to tap first, and which ones next. And, because of the different growth rates and tax rates applied to your different accounts, your calculator can introduce major errors if it doesn’t match your real-world withdrawal pattern.
For most traditional retirement accounts in the U.S., starting at age 70 the government requires you to make withdrawals and pay taxes, known as Required Minimum Distributions (RMDs). The exact amount is computed using a table with different ratios for each year, based on your average life expectancy. A high-fidelity calculator will get the timing and amounts right, automatically, so you don’t have to think about the details.
To understand the impact of RMDs on retirement wealth, I analyzed a 55-year long scenario starting with a couple age 40 and 35, making about $150,000 annually between them, retiring around 60, and collecting an average amount of Social Security. Disabling RMDs for this couple resulted in an ending net worth 67% higher than the actual, real-world value! Lesson learned: For detailed retirement cash flow and tax strategy planning, ignore RMDs only at your own peril. If your retirement calculator doesn’t handle them, get another calculator.
Detailed Income Tax Calculations
We’ve saved the most difficult topic for last. It can be very tempting to ignore federal income tax calculations when it comes to retirement planning, because the complexity is overwhelming. That’s why the majority of lower-fidelity retirement calculators use a single, simplistic effective tax rate instead of performing detailed tax calculations with inflation-adjusted marginal tax brackets. The problem with effective tax rates is that they put the burden on you, the user, to distill your tax situation into a single, artificial number. For serious retirement planning that’s unrealistic and can be dangerously inaccurate.
Read next: Do You Need a Financial Adviser?
In my recent post on effective tax rates I showed that the effective rate over the course of one typical retirement varied from about 24% to 0% to 8% to 9%. Which one was right? All of them, and none of them. Attempting to use an average effective rate produced a difference between the ending net worth determined by a high-fidelity calculator of $300,000!
In his similar analysis, Matthews found that attempting to guess at effective tax rates can lead to magnified errors. In one of his studies, varying effective tax rates introduced 8% errors in the final savings balance for each 1% input error! Can you guess your effective tax rate for each year of retirement within 1%? Very unlikely. A simplistic numerical average is simply inadequate to accurately capture the complex U.S. tax code.
The best solution, if you need accurate retirement numbers, is to find and use a calculator that correctly performs detailed tax calculations.
So we’ve reviewed four critical design features that qualify a retirement calculator or financial planning software as a serious modeling tool you can entrust with one of your life’s most important decisions. If only one of these features is missing, your results can easily be wrong by tens of percent. If several are all missing together, as is the case in many low-fidelity retirement calculators, your results could be off by hundreds of percent. The answers will be essentially useless for detailed retirement planning. You’ll be flying blind as you make decisions involving potentially hundreds of thousands of dollars, and your happiness and security in later years.
Darrow Kirkpatrick is a software engineer and author who lived frugally, invested successfully, and retired in 2011 at age 50. He writes regularly about saving, investing and retiring on his blog CanIRetireYet.com. His latest book is Can I Retire Yet?.