Thursday, March 24, 2011

What Is Your OTHER Number?

Many financial planners are now touting something called your retirement number.  This is the amount of money that you will need in order to retire comfortably.  Of course, this is based upon a number of assumptions (life expectancy, inflation, Social Security, etc); however, it provides a target amount for which to shoot.  The thought is that once you know how much you might need, you can then determine how much you need to save each year.  That, of course, brings us to a second number that is of utmost importance when planning for retirement:

Your estimated investment returns

What investment rate of return you assume has a huge impact on the amount of money you think you might need to save.  Let's illustrate it with an example...

You've plugged all of your information to the magic retirement number calculator, and it says that you need one million dollars in order to retire comfortably.  You have 40 years to go until your retirement.  You run the numbers assuming a 7% rate of return on your investments, and you determine that you need to put aside about $5,000 a year to reach your goal.

Now let's fast forward 40 years later, and you are now on the precipice of retirement.  For whatever reason, your rate of return fell short of your assumption by a mere 1%.  By how much did you miss your retirement goal?  You couldn't have missed by that much.  After all, 1% isn't a lot, right?  Well, you would be wrong.  By overestimating your rate of return, you have missed your retirement number by over 22%!  Ouch!

On the plus side, if you underestimated by 1%, you will overshoot your retirement number by almost 30%.  Wow!

Here is a quick summary of the impact of a 1% variation over 40 years:

Rate of ReturnTotal SavingsDifference% Difference
6%$768,809.83 $(224,365.73)-22.59%
7%$993,175.56 $- 0.00%
8%$1,290,282.59 $297,107.03 29.91%

Economists call this type of experiment sensitivity analysis.  Sensitivity analysis studies how the change in one variable (interest rate in this case) affects the outcome (total savings in our example).

Another interesting observation is that the effect of a 1% variation in the assumed interest rate increases as your time horizon increases.  Consider the same type of analysis over 20 years...

Rate of ReturnTotal SavingsDifference% Difference
6%$178,927.96 $(21,049.51)-10.53%
7%$199,977.46 $- 0.00%
8%$223,809.82 $23,832.36 11.92%

...or over 30 years...

Rate of ReturnTotal SavingsDifference% Difference
6%$390,290.93 $(77,013.00)-16.48%
7%$467,303.93 $- 0.00%
8%$561,416.06 $94,112.12 20.14%

The longer your time horizon, the more a slight variation in your rate of return makes a difference.  Obviously, variation on the high side is a good thing.  After all, who wouldn't want to have more money in retirement than anticipated?  However, missing the mark on the low side can have serious consequences.  It could mean the difference between retiring comfortably versus having to scrimp in your golden years.  Therefore, it makes sense to choose your other retirement number, your assumed investment return, as conservatively as possible.  Of course, that is easier said than done.  Choosing a lower assumption means that your retirement contributions need to be higher.  Putting on the rose-colored glasses means that you fool yourself into thinking you don't have to put aside as much each year.

Consider the State of California... 

The California Public Employees' Retirement System (CALPERS), which manages the pension fund for state workers, decided to leave its assumed investment rate of return at 7.75%.  This was despite the fact that the plan's chief actuary reccommended lowering it to 7.5%.  ONn the one hand, keeping the assumed rate at 7.75% means that the cash-strapped state would not have to bump up its retirement contributions.  This is one way to help meet the budget shortfall in the state.  However, let's say that their actuary is right and their actual investment return is only 7.5%.  That means that either future retirees will have to take less, or future taxpayers will have to make up the difference.  Either way, it seems like a big gamble.

1 comment:

  1. Nice blog, you are representing such informative information through this blog. Many financial planner consultants are now touting something called us retirement number. The amount of money that we will need in order to retire comfortably. To provides a target amount for which to shoot. The thought is that once we know how much we might need, we can then determine how much we need to save each year.