Retirement Nestegg - Calculator Explanation

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This next calculator is pretty cool. Very similar, in fact, to alot of the retirement “What If” scenarios that you can model for clients with more in depth planning software. What you are actually seeing, with these calculators, is a stripped down version of the more formal financial planning software.

These calculators are the engines that make all that fancy software go. Without further ado, lets dive into this ‘Nestegg’ …

Retirement Nestegg Calculator

One thing you must be aware of when using this calculator is its hyper sensitivity. With many of these calculators, there are often only one or two input fields that can dramatically impact the results. With this particular calculator, if you change just about any field, you will see big swings in the future results.

So before you start using this one, I would advise you to test out all the different fields and get a firm grasp on things before proceeding. Let’s dissect the screenshot I put together here…

Current Age

John is 35 yrs old

Household Income

Your total household income. If you are married, this should include your spouse’s income. Since John is married to Michelle, we include their total household income of $125,000

Rate of Return Before Retirement

This is the annual rate of return you expect from your investments, after taxes, for the years leading up to our projected age of retirement at 66.

The actual rate of return is largely dependant on the type of investments you select. From January 1970 to December 2006, the average compounded rate of return for the S&P 500, including reinvestment of dividends, was approximately 11.5% per year (source: standardandpoors.com). During this period, the highest 12-month return was 61%, and the lowest was -39%. Savings accounts at a bank pay as little as 1% or less.

It is important to remember that future rates of return can’t be predicted with certainty and that investments that pay higher rates of return are subject to higher risk and volatility.

In our example, I have once again gone with a rate of return of 8%. Much like either of the first two fields if you alter this field it will have a dramatic impact on the monthly number. For instance, if you were to keep everything else as is, and move the rate of return up to 10%, the monthly savings number drops from $798 to $250. Wow.

Years of retirement income

Total number of years you expect to use your retirement income. You can base this on average life expectancy. In our screenshot, we’re retiring at age 66, so we’ll model an additional 15 years, which takes us to age 81.

Expected salary increase

Annual percent increase you expect in your household income. Be careful with this number as well. Slight adjustments here can create big swings that influence just about every other field. I’m going to keep it at an even 3% to keep up with the historic rate of inflation.

Age of retirement

Age you wish to retire. John will be retiring at age 66.

Current Retirement Savings

Total amount that you currently have saved toward your retirement. Include all sources of retirement savings such as 401(k)s, IRAs and Annuities. Between John and Michelle they currently have $80,000 saved up.

Rate of Return during retirement

This is the annual rate of return you expect from your investments during retirement, after taxes. Generally speaking, it’s often lower than the return earned before retirement, due to more conservative investment choices, to help insure a steady flow of income with less market risk.

It is important to remember that future rates of return can’t be predicted with certainty and that investments that pay higher rates of return are subject to higher risk and volatility. In our example, we reduced the retirement rate to 6%, by doing so we didn’t help our ‘What If’ scenario much.

Percent of income at retirement

The percent of your pre-retirement household income you think you will need to have in retirement. This amount is based on your income earned during the last year you will work. You can change this amount to be as low as 80% and as high as 120%. Typically, with my clients I model 80-85% replacement income during retirement. I used 80% here.

Expected rate of inflation

What you expect for the average long-term inflation rate. A common measure of inflation in the U.S. is the Consumer Price Index (CPI), which has a long-term average of 3.1% annually, from 1925 through 2006. We’re going to keep our rate at 3%.

If you are married

Married couples have a higher maximum social security benefit than single wage earners, which factors in quite heavily if we check off ‘to include social security’ in our calculation. Which ofcourse we do check.

To include Social Security

Check this box if you wish to include social security benefits in your retirement planning. Social Security benefits can automatically increase each year based on increases in the Consumer Price Index. Including a spouse increases your Social Security benefits by 1.5 times your individual estimated benefit.

Note that this calculator assumes that you have only one working spouse. Benefits could be different if your spouse worked and earned a benefit higher than one half of your benefit. If you are a married couple, and both spouses work, you may need to run the calculation twice - once for each spouse and their respective income. This calculator provides only an estimate of your benefits.

The calculations use the 2007 FICA income limit of $97,500 with an annual maximum Social Security benefit of $25,392 per year for a single person and 1.5 times this amount for a married couple. To receive the maximum benefit would require earning the maximum FICA salary for nearly your entire career. You would also need to begin receiving benefits at your full retirement age of 66 or 67 (depending on your birthdate). Your actual benefit may be lower or higher depending on your work history and the complete compensation rules used by Social Security.

In our screenshot we’ve included the Social Security stream in our retirement Nestegg analysis. The other assumption made is that Michelle doesn’t work and takes care of their baby boy, Alan.

In Conclusion

The ‘nestegg’ calculator tells us in order to maintain a comfortable lifestyle in retirement, John is going to need just under three million dollars saved at age 66 or the equivalent of $798 saved a month. At first glance this is a pretty big number and a scary predicament to be in but you have to remember this is a pure retirement needs analysis.

There is no mention of adding any pensions or non retirement assets that the client may have to supplement retirement; for example, if John had a pension it would dramatically improve the situation.

The biggest thing that I think you should get out of this is how sensitive these calculators are. It’s so important to be realistic in the rates and numbers you input. I showed how a 1% difference (over a 30 year period) in the pre-retirement rate of return knocked down the savings needed from $798 to $250 monthly. I’ve told you in the past how bad things can be if the assumptions are unrealistic. These calculators are very powerful tools and need to be treated with respect.

This calculator serves its purpose and exposes weaknesses in your retirement planning but it’s a bit idealistic. The ‘nestegg’ calculator assumes in order to plan for retirement you need to satisfy retirement goals with monies specifically set aside for retirement. I don’t think so…

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