The Hidden Benefits of Using a Retirement Calculator
Kailey Fralick, The Motley Fool
Updated
Here's what you need to know about online retirement calculators, which purport to take your personal information and tell you exactly how much money you'll need down to the dollar: They are wrong. Flat out wrong.
The truth is, there isn't a calculator on earth that can tell you how much money you'll need for retirement, no matter how many factors you plug in: spending, life expectancy, rate of return, inflation. There aren't any financial advisors who can, either. The best anyone can do is estimate, because there are so many unknowns. You can't predict how long you're going to live, how the value of the dollar will change, and how much your investments will grow. There's no way to foresee unexpected expenses or peek into the future and plan accordingly.
Two elderly people use a calculator
Image Source: Getty Images
But that doesn't mean these retirement calculators are completely worthless. Here's a brief overview of how to use these online tools to get the best possible estimate and how to interpret the results that these handy resources spit out.
How do retirement calculators work?
Retirement calculators typically look at the same data. Key factors include:
Your life expectancy
Your expected retirement age
The rate of inflation
Your expected investment rate of return
Your expected retirement expenses
The trouble is, each of those factors is unpredictable. So calculators do the only thing they can do: estimate based on historical data. For example, many basic retirement calculators assume a 3% annual inflation rate, because that's what you get when you average year-over-year inflation from the 1920s to present. But actual inflation rates vary wildly each year. In 1979, the inflation rate was more than 13%. While spikes this severe are uncommon, even a single percentage point can impact how much you need for retirement savings.
If you estimate you'll need $40,000 annually for living expenses over retired 20 years and you figure in a 3% annual rate of inflation, you'll determine that you need about $1,075,000 in total. But change the average inflation rate to 4%, and you now need $1,191,000 -- an additional $116,000. Not exactly peanuts.
Some calculators automatically input a 3% annual inflation rate. If the historical average turns out right, you might get an accurate measurement. But historical data can't accurately predict future trends; if you just take the retirement calculator at its word, you could end up with far less than you actually need.
A similar scenario could play out if your calculator automatically assumes the rate of return on your investments. If it figures high, you may think you're on track for your retirement goals, but if your portfolio then underperforms, you would soon realize that you're not as prepared as you thought.
The best retirement calculators enable you to play around with inflation and rates of return, to get low and high estimates of how much you might need. And you're always free to manipulate the numbers for your life expectancy, retirement age, and living expenses in retirement. Calculating a low estimate and a high estimate and then planning for retirement by using that range as a guide is a good way to improve the likelihood that your planning and saving is on target with what you'll really need.
Some calculators may take more data into account than the information listed above. Some include average healthcare costs. Medical cost inflation often outpaces the standard inflation rate, so calculating this separately will provide a more accurate estimate. Some tools also enable you to factor in the income you'll receive from Social Security and pensions.
Make the most of retirement calculators
You can pretty much guarantee that any retirement calculator will compute an inaccurate estimate, but there are still many advantages to doing this exercise. You can try different scenarios to see how certain changes play out, which can help you perfect your retirement planning and adjust your expectations. You're able to see how your savings goal will be impacted by different events such as working longer, changes in spending, or living even longer than you expected.
It's best to try several different calculators; adjust the inflation rates and investment rate of return up and down. If you want to be conservative, aim to save for the highest estimate you receive. It's always good to have a cash cushion because you never know when an unexpected expense might arise or when your retirement portfolio may take a hit. Plan for retirement using a range of a low estimate and a high estimate, so that you fall somewhere in the happy, comfortable middle.
Don't get complacent once you have your first range of estimates from a few retirement calculators. Run the calculations again every few years. New historical data may indicate a different average rate of inflation or investment returns than you had calculated previously. Keep adjusting your retirement savings goals to keep up with the latest information and pay attention as previous unknowns impacting your retirement become certainties.
Retirement calculators can help you navigate the murky waters of retirement planning, but only if used the right way. Recognize them for what they are -- a flawed estimate-- and periodically reassess your goals to stay on track. Most importantly, getting familiar with using these calculators and habitually going back to them to check your progress will keep retirement planning in the forefront of your mind for life, a hugely important benefit.
