Discover The Critical Flaws Hiding Behind Conventional Wisdom And Learn Why The Answer May Be Far Simpler Than You Ever Imagined…
Retirement planning isn’t the precise science you would like it to be…
Surprisingly, most people don’t “get” how the process works. Several myths have earned conventional wisdom status despite being wrong. These myths can be very expensive and undermine your financial security.
The truth about retirement planning is startlingly simple because the essential principles can be reduced to just 2 basic formulas.
In this article I’ll reveal several retirement planning myths while also diving deeper into these 2 critical wealth building formulas so that you have the tools necessary to secure your financial future – but first a quick story…
Missing The Forest For The Trees…
Let’s start with the basics…
Financial freedom (or retirement security – same thing) 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!
The financial freedom game is about building passive income and controlling expenses. When income exceeds expenses you are financially free. Simple enough.
There are three broad asset classes to build passive income – business, real estate, and paper assets. None is better than the other although each offers distinctly different characteristics.
Amazingly, if you look at most 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.
Can you guess why? Look at the advertisers and services that support these free online calculators… brokerages, financial planners, and others in the business of selling paper assets. Not a coincidence.
Forgive me if this all seems painfully obvious, but the masses don’t get it! They’ve bought into the single asset class myth. Let me give you an example…
The other day my Ultimate Retirement Calculator was reviewed on a popular and respected blog and the readers came up with a variety of well-intentioned but petty criticisms. The site owner demonstrated his solid knowledge by noting how he used the calculator to develop retirement scenarios, but his readers couldn’t see the forest for the trees…
- “It doesn’t include separate inputs for each spouse.” (Answer: Who needs the complication? Just aggregate both spouses together. It’s called community property for a reason.)
- “It doesn’t provide separate tax rates before and after retirement.” (Who cares? Different tax rates would only be meaningful if your taxable income fell dramatically after retirement. Unless financial freedom equals poverty this added detail would only introduce meaningless complication.)
- The comments continued with little criticisms about minute details that had little practical bearing on the final calculation. They were focused entirely on the wrong thing!
More importantly, they completely missed the unique value of this calculator. Nobody provided positive comments about the important features that set this calculator apart from the competition…
- It is simplified down to only the essential numbers so that it is acceptably accurate without being excessively complicated.
- It allows you to change any input and hit “recalc” so you can test a variety of combinations efficiently and quickly.
- It allows you to include a future lump sum payment so you can model an inheritance, selling investment real estate, or selling a business at a future date.
- It allows you to set up three separate income streams so you can model income from real estate, Social Security, annuities, businesses or whatever unique plan you develop to make passive income exceed expenses.
The sad reality is these critics were stuck in the minute details of forecasting a mythical magic number for paper asset accumulation and never noticed the important points. They were distracted by detail issues and it led them in the wrong direction. Sure paper assets are important, but they are only one of three asset classes.
So that is the first mistake in retirement planning – undue focus on a single asset class… namely paper assets.
It is 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 Magic Number!
The next mistake is to believe in the mythical magic number – that amount of savings the retirement calculators’ claim you must accumulate to enjoy financial security.
The primary symptom of the 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 and all the other details are just that… details.
Conversely, if you get these important numbers wrong then you will fail completely no matter how detailed your analysis.
It’s as simple as that.
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…
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.
In my recent article – How Anyone Can Retire in 10 Years (or Less!) – I demonstrated how a super-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…
- 10% savings rate = 42 years
- 20% savings rate = 32 years
- 40% savings rate = 21 years
- 50% savings rate = 17 years
- 60% savings rate = 14 years
- 70% savings rate = 10 years
- 80% savings rate = 7 years
(Ed. Note: These numbers are only scientifically valid for very high savings rates (i.e. 60%-80%) because longer time horizons introduce complication from compound returns and inflation as explained in the next section of this article. Lower savings rates (or longer time horizons) are shown for illustration only. See the full article for all the details…)
This is not some crazy math theory. It explains exactly how I retired at age 35. I saved roughly 70% of a substantial income and never allowed spending to rise with income. It didn’t take long for my assets to grow sufficiently large to support my lifestyle.
It is a brain-dead simple, scientifically accurate way to achieve the goal.
One of my favorite quotes is, “If you want to know how long it will take anyone to achieve anything just look at how much of their resources (time and money) they dedicate to the goal”.
This savings formula is saying the exact same thing. If you want to know how long it will take you to achieve financial freedom just look at the percentage financial resources you dedicate to the goal. Remarkably simple… and effective. It just plain works.
Again, don’t get hung up on distracting details. Keep it simple and focus on one thing – maximize your savings – in any form.
The goal is to direct income away from consumption and into the asset column. Once you have assets then the next critically important set of numbers enters the picture…
Return On Investment Minus Inflation Determines Amount Of Assets Required
The amount of savings you need to support any given level of spending is a function of your return on investment minus inflation.
This is the BIG ONE! Nothing else comes close when planning retirement with paper assets.
All the picky little details that arise when people seek to perfect their magic retirement number are dwarfed by this one ratio – ROI minus inflation.
The reason is simple – compound returns multiply little differences into HUGE differences over long periods of time. This isn’t about turning mole hills into mountains: this is about turning grains of sand into the Himalayas!
I’ve worked with these numbers all my adult life and it still amazes me when I work through the process with a financial coaching client and see the effect. Seriously, try it for yourself.
Go to my Ultimate Retirement Calculator right now and punch in your best guesstimates to figure how much money you need to retire. Seriously, do it right now before reading any further. Don’t worry about perfection. Your best estimates are good enough for this exercise.
When inputting expected lifespan use age 100 unless you have known health issues. Why age 100? Because research already shows high odds of a healthy couple at age 65 having one spouse live past 90. Additionally that number increases every decade so just use 100 as a round number.
You will get a lot more value from this if you do the exercise right now! Please, don’t trust me. Prove it for yourself. It will only take two minutes and could be the most eye-opening two minutes you spend all week.
Once you fill out the calculator with your base level numbers then write down the “magic retirement number” that it provides.
Next, try perfecting your magic number by “tweaking” a few variables like tax rate, retirement age, and other details similar to the critical comments cited earlier recommended. The only rule is you can’t touch the two key inputs highlighted in this article – return on investment and inflation. Everything else is fair game.
Notice that your magic number changes with each variation, but the changes are only fractional. Your estimates for how much money you need to retire remain in the same ballpark as your original number. The calculation is relatively stable.
Now, using the exact same inputs as before, raise your inflation rate by 2% while simultaneously reducing your return on investment by 2% (but make sure you’re sitting down first )
See what I mean? For most people this small change will literally multiply the amount you need to retire several fold. It should knock your original estimate right out of the ballpark, over the river, and into the next state.
That is why I call all the other variables “details” and label these two ratios “critical”. It’s just the way the math works.
Focus On What Matters And Forget The Rest
Now let’s take this lesson a step further…
There is a little problem with this analysis that I disclosed in the previous section (showing how anyone can retire in 10 years). I explained that long periods of time introduced variables that could not be reliably estimated.
In other words, this key ratio (ROI – inflation) cannot be forecast with any accuracy. It is 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. Yet, every retirement calculator requires you to estimate what it will be. If you estimate wrong then your whole calculation is wrong.
Seriously, Ph.D. economists who study the subject extensively can’t reliably predict inflation one year into the future. It is an absurd joke that you are expected to bank your retirement plan on a layman’s guess for 30 years into the future when trained experts have no clue.
This problem should be intuitively obvious to anyone who can remember back to 1980 (interest rates were in the “teens” and stocks had gone essentially nowhere for 25 years). How many people back then forecast the beginning of the greatest stock market rise in history with long term interest rates declining to historic lows? I was working on the sales side of my hedge fund business meeting with CEO’s and retirement plan fiduciaries and I can tell you with certainty almost nobody saw it coming.
Still not clear that ROI and inflation can’t be predicted? Then remember back to the 2000 bull market top and recall how many soothsayers warned you about the coming decade of flat performance, record volatility, and artificially low interest rates? You could count them on one hand and still have fingers left over.
Similarly, at the top of the real estate bubble in 2007 how many forecasters correctly took defensive action and got out of the way before the bubble burst? I did and I can tell you it was a very lonely position. (If you need more evidence proving the fallacy of forecasting see a complete analysis here.)
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 magic number requires you to forecast all these variables accurately. If your forecasts are wrong by just a little bit then your entire retirement estimate isn’t worth the paper it’s printed on.
In plain language, the magic retirement number is a myth. That is why retirement planning done right requires scenario analysis – not creating a mythical magic number.
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.
Shocking, but true!
Now you understand why I literally laughed when someone criticized my retirement calculator for not allowing individual input for each spouse. They missed the whole point. Detail like that is meaningless complication – totally irrelevant. It is 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 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 if it is better to delay Social Security or start payments early.
- Try modeling several factors together.
In other words, use the retirement calculator to put numbers behind different life plans for your financial future. Each example will teach another principle just as the examples in this article teach principles.
That is how you use retirement calculators properly, and that is why my Ultimate Retirement Calculator is designed specifically to facilitate a simple process for scenario analysis.
The Ultimate Retirement Calculator is designed with three specific objectives in mind…
- It omits meaningless complication and non-essential detail thus reducing barriers to you completing the calculations. It is more important to plan retirement roughly than not do it at all. It is also important to not get so caught up in minute details that 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.
In short, this calculator is designed for scenario analysis – not mythical magic numbers.
Scenario analysis is how you blend life planning with retirement calculators to produce a realistic road-map to achieve financial security. It is a practical approach for retirement planning that avoids the myths and traps that have unfortunately become conventional wisdom.
Building wealth for retirement is not complicated. The process is governed by strict mathematical principles that imply certain clear objectives.
Starting with the basics, the goal is financial freedom which is defined as passive income exceeding expenses. This focuses your financial plans on just two objectives – grow passive income and control expenses. Simple enough.
Second, most retirement calculators implicitly assume there is only one asset class (paper assets) and preach the magic number myth. Neither is true. That is why I designed the Ultimate Retirement Calculator so that you have a tool that works with the “New Retirement” reality – multiple asset classes, phased retirements, and much more.
Finally, when modeling paper assets as part of your retirement plan it is 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 key is to not fall prey to the magical number myth and don’t get caught up in excessive detail. The truth is retirement planning is essentially a bet on an unknowable future that requires assumptions about inflation and return on investment that cannot be accurately predicted. That is why excessive detail is a fool’s errand.
Even though the magic number myth taught by most other educators is wrong, you should not conclude that retirement calculators are a waste of time. They are not.
Studies by Employee Benefit Research Institute demonstrate that people who estimate how much money they need to retire 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 a framework that is immensely valuable. They will 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.
Just don’t mistake the map for the territory by believing the magic number produced is even remotely accurate.
Calculators are best used for mapping a path and putting numbers behind your life plan. They are indispensable for seeing the financial impact of “what if” scenarios so that 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 cannot be forecast with scientific precision… and neither can your retirement.
Finally, if you got value from this article please let me know by liking, linking and +1 this article and the retirement calculator resource page here. I appreciate your support and welcome your feedback in the comments below…
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- 5 Reasons Why You Can’t Trust Retirement Calculators – Unmasks the magical number myth – warts, blemishes, and all.