Retirement Calculators: hubris and folly?

Many personal finance sites, as well as banks, brokers, and accounting pages feature retirement and goal planning calculators.  These tools are certainly useful, but with caveats.

If a 35 year old person in the early stages of their career uses such a calculator to frame the numbers around their own projected retirement ~ 30 years later, how likely is it that the numbers turn out to be accurate?  A reasonable set of assumptions to plug into such a calculation would include (not exclusively):

• number of years to retirement
• availability of an employer sponsored retirement plan
• ability to contribute to such a plan, at what rate, and any potential company match
• the pace of salary advancement
• average expected return on investment
• average expected pace of inflation
  
• projected spending in retirement
• number of years to enjoy retirement

It should be obvious from the list that there are a lot of variables in this math!  In some ways, making accurate predictions about a person's financial condition decades from now is like landing a jet on an aircraft carrier at night, in the rain, and no assistance from the control tower.

This is not to say that the calculators have no value; in fact, this sort of tool is very helpful in starting deeper conversations around financial planning and managing expectations around goals.  Our hypothetical 35 year old (or 45 year old!) should take the time to run the calculations, but should take care with the results...any slight tweak in one assumption or three will make dramatic changes in the final numbers.  And if there is any one thing certain in life, it is that life can be very uncertain!

Below the jump I will share one very simple example of how even slight volatility in assumptions can impact results.

Let's consider two examples of a 20 year accumulation goal.  In both cases, the investor begins with $10,000, wishes to grow that amount in a manner consistent with the risk and return of the S&P 500 equity index.  The only difference in the two situations is the particular 20 year period.

Sample data #1: 4/11/1988 to 4/11/2008 (using the S&P 500 total return index, which includes dividends), the chart shows a 20 year net change in value of 677.3%

^SPXTR data by YCharts

Sample data #2: 4/11/1993 to 4/11/2013, the chart shows a 20 year net change in value of 425.4%

^SPXTR data by YCharts

So what does that mean for our two scenarios?  In both cases, our hypothetical investor has the same time horizon and risk tolerance (defined very simply here as "20 years" and "consistent with the S&P 500"), but has very different outcomes.  Scenario #1 leads to a final dollar amount of ~ $67,700; scenario #2 finishes the 20 years at ~ $42,540.

It is impossible to know in advance what the next 20 years will bring, and in the case of these two samples, it is apparent that the range of possibilities is wide.  Even with two "positive" examples as these resulting in significant gains, there is a difference of $25,000 in final money!

A robust and holistic financial plan will not erase all of that uncertainty, but a well constructed plan could provide some cushioning in expectations, or otherwise build in some factors of safety around the retirement planning assumptions.