Retirement planning really isn’t the precise science you would like it to be…
Retirement planning is about guesswork.
Not random guess, but educated guess.
Shockingly, most people don’t comprehend how the process works. Several myths have earned rule of thumb status despite being outright wrong.
These myths can jeopardize your financial security.
The gist about retirement planning is startlingly simple because the essential principles can be reduced to just 2 fundamental equations. It is not some retirement magic number.
What are they?
We will discuss in detail these 2 factors…
But first, a quick recap
Missing The Forest For The Trees…
Let’s start with what you already know:
Retirement security occurs when your passive income exceeds your expenses.
Notice how there are just two variables to this equation: passive income and expenses. That’s it – nothing complex!
Financial freedom, as cliched as it may appear, is about building passive income and controlling expenses. When income exceeds expenses, you’re financially free. Simple enough.
There are three broad asset classes to build passive income – business, real estate, and paper assets.
Each of the asset class has its pros and cons, each offers distinctly unique characteristics.
Unfortunately, when you first encounter any retirement calculators, you would never know there are three asset classes to build retirement with.
They usually assume only one asset class – paper assets. They provide no mechanism for adding additional income streams from businesses or lump sum payments from selling real estate holdings.
Instead, they just model the growth of paper assets.
Forgive me if this all seems painfully obvious, but the masses don’t get it! They’ve bought into the single asset class myth.
Sure, paper assets are important, but they’re only one of three asset classes.
So that’s the first mistake in retirement planning – undue focus on a single asset class… namely paper assets.
It’s a myth perpetuated by a financial industry that has a vested interest in convincing you to spend your hard-earned retirement savings on the paper assets they sell (stocks, bonds, mutual funds, ETF’s).
The truth is there are three viable asset classes for retirement planning and your modeling should include all assets appropriate to your life situation.
With that said, most people’s retirement plans are dominated by paper assets, so let’s go deeper into this subject by examining several other mistakes commonly made when planning retirement using this asset class…
Retirement Planning Done Right Is About Scenario Analysis – Not The Mythical Retirement Magic Number!
The next mistake is to believe in the mythical retirement magic number – that amount of savings the retirement calculators claim you must accumulate to enjoy financial security.
The primary symptom of the retirement magic number myth is a desire to apply increasingly detailed analysis in a futile effort to increase your retirement number accuracy.
Don’t waste your time! It doesn’t work that way…
Victims of this myth ask questions like the critics above because they believe every little number, tax rate, and detail is somehow marginally relevant to their goal of knowing how much money they need to retire.
The reason is because all those details are completely dwarfed in significance by one or two critically important numbers that will make-or-break the analysis.
Get these big numbers right (the main course) and all the other details are just that… sidelines.
Conversely, if you get these important numbers wrong, then you’ll completely fail no matter how detailed your analysis.
Let’s look at how these critical numbers monopolize the retirement planning process when using paper assets so that you don’t make the same mistake…
Critical Number #1: Savings Growth As A Percent of Spending
The first critically important number when planning retirement with paper assets is the percentage of income saved versus spent.
An ultra-aggressive savings rate would allow you to skip all the calculators by reducing retirement planning to one simple ratio that forecast with scientific precision how long it would take to become financially independent.
The numbers were as follows…
- 50% savings rate = 17 years
- 60% savings rate = 14 years
- 70% savings rate = 10 years
- 80% savings rate = 7 years
This isn’t some incomprehensible math theory.
The question is, if you want to retire earlier than your peers, you got to look at how much of your resources (time and money) you dedicate to this very goal”.
Remarkably simple… and effective. It just plain works.
Principle: If you want to retire faster, then reduce your spending and/or raise your income in proportion to your income growth. The higher the percentage, the faster and more reliably you’ll reach the goal.
Again, don’t get analysis paralysis get to you.
Try your very best to channel income away from expenditure and into the asset column. Once you have assets, then the next critically important set of numbers becomes relevant.
Critical Number # 2: Return On Investment Adjusted for Inflation Makes or Break your Retirement Nest Egg
The amount of savings you need to support post retirement lifestyle is a function of your return on investment minus inflation.
This is the HUGE ONE! Nothing else comes close when planning retirement with paper assets.
All other details that arise when people seek to perfect their magic retirement number are undermined by this one ratio – ROI adjusted for inflation.
The power of compounding multiplies small percentages of 3% inflation into HUGE differences over long periods of time (20 to 30 years).
This isn’t about turning mole hills into mountains; this is about turning grains of sand into the Himalayas!
When inputting expected lifespan, try putting age 100 unless you have known health issues.
Next, try perfecting your retirement magic number by “tweaking” a few variables like effective tax rate, retirement age, etc.
However, make these 2 inputs constant – return on investment and inflation.
Notice your retirement magic number changes with each variation, but the changes are fractional.
You will notice that your approximation for how much money you need to retire remain in the same ballpark as your original number.
Now, using the exact same inputs as before, just hike the inflation rate by 2% while simultaneously reducing your return on investment by 2%.
See what I mean? For most people, this small change will literally multiply the amount you need to retire several fold.
You now should see a big difference.
That’s why you should treat the other variables are “minor details” and consider these two ratios “critical”. It’s just the way the math works.
Concentrate On What is Critical And Pay Scant Regard to the Rest
In the previous section above, I elaborated that long periods of post retirement years comes with numerical uncertainties that couldn’t be reliably estimated.
Specifically, this key ratio (ROI – inflation) can’t be approximated with any accuracy.
It’s another myth of retirement planning because nobody knows what their inflation rate or return on investment will be (within 2%) over the next 15-30 years.
It’s a complete guess – total fiction. And worse, it is never a constant.
Yet, every retirement calculator requires you to estimate what it will be and assume it will be constant over 2-3 decades.
This problem should be intuitively obvious to anyone who can remember back to 1980 (interest rates were in double digits and stocks had gone essentially downhill for 25 years).
How many people back then forecast long term interest rates declining to historic lows?
I can tell you with certainty almost nobody saw it coming.
Given these facts, what makes you think the next 15-30 years will be any different? The future is unknowable; yet, a retirement forecast built on the mythical retirement magic number requires you to forecast all these variables accurately.
In plain language, the magic retirement number is a myth. That’s why retirement planning done right requires scenario analysis – not creating a mythical retirement magic number.
The magic retirement number doesn’t exist. Base your retirement plans on scenario analysis instead.
The truth is small errors in key estimates cause such large errors in the amount you need to retire that the whole idea of relying on the calculation is essentially foolish.
Detail like that is meaningless complication – totally irrelevant. It’s equivalent to arguing whether a right or left turn is better for getting out of a railroad crossing when a freight train is heading toward you at 70 miles per hour.
Retirement calculators are useful, but only for scenario analysis – not determining your retirement magic number.
- Use retirement calculators to model a wide range of variables to produce a confidence interval.
- See what happens if you add 10 years of additional income – part-time work, consulting, or whatever might interest you to take the pressure off savings and allow your assets more time to grow.
- Try modeling real estate rental income that adjusts for inflation and rises when you pay off the mortgage.
- Try modeling what happens when you receive a lump sum inheritance, sell a home or business.
- Try modeling the difference between a conventional asset allocation and a dividend growth portfolio.
- Try modeling several factors together.
In other words, use the retirement calculator to put numbers behind different life plans for your financial future.
The Practical Retirement Calculator is designed with three specific goals in mind:
- It excludes meaningless complication and non-essential detail, thus reducing barriers to you completing the calculations. It’s more important to plan retirement roughly than not do it at all. It’s also important to not obsessed with the minute details you deceive yourself into believing the output is scientifically accurate.
- It provides a simplified platform so that you can model various real-life scenarios using all three asset classes (not just paper assets like competing calculators). No other calculator allows that flexibility which is essential for the way modern retirements are planned.
- It allows you to quickly and easily build confidence intervals by varying single inputs and seeing how it affects overall output.
Scenario analysis is how you blend life planning with retirement calculators to produce a realistic road-map to achieve financial security.
It’s a practical approach for retirement planning that avoids the myths and traps that have unfortunately become conventional wisdom.
In Summary, what Retirement Planning is about…
Wealth accumulation for retirement isn’t complex.
The end goal has always been passive income exceeding expenses.
En route to this goal, the primary focus is always on just two objectives – grow passive income and control expenses. Simple enough.
The other thing is that most retirement calculators implicitly assume there’s only one asset class (paper assets) and preach the retirement magic number myth. Neither is true.
The practical reality of modern age retirement – it consist of multiple asset classes, phased retirements, and much more.
Finally, when modeling paper assets as part of your retirement plan, it’s essential to focus on the two big ratios that account for the bulk of variation in the output:
- Your savings as a percent of your income
- Return on investment minus inflation
The truth is retirement planning is essentially a bet on an unknowable future that requires assumptions about inflation and return on investment that can’t be accurately predicted. That’s why excessive detail is a fool’s errand.
Although the retirement magic number myth is wrong, you shouldn’t dismiss retirement calculators or retirement planning as a waste of time. They aren’t.
Planning makes you estimate how much money you need to support post retirement lifestyle, henceforth spur you to take more effective actions toward saving for retirement and produce greater results.
Retirement calculators should be used for scenario analysis and to model different life plans for retirement. They provide an immensely valuable framework.
They’ll teach you essential principles that will positively impact your financial decisions and have practical application for how you invest, manage your money, and design your life.
Retirement calculators are best used for charting a road map and quantifying the dollars & cents behind your life plan. They’re indispensable for seeing the financial impact of “what if” scenarios so you can make better informed decisions about the future.
With that said, always remember to treat the output with caution and never confuse mathematical science with art.
The future can’t be forecast with scientific precision… and neither can your retirement.