There are quite a range of financial planning tools that attempt to shed light on the question of how much money one should save for retirement. Among the free online tools, I feel that the very best is the Retirement Income Calculator developed by T. Rowe Price. Called the RIC for short, this tool won the 2009 Mutual Fund Education Alliance Star Award for Best Retail Online Innovation.
I have followed the evolution of the RIC for years, and the latest generation of the tool is remarkably intuitive and easy to use.
What does this tool do? You enter your age and a variety of other pertinent information, including specifying your asset allocation (or you can use a default). The tool then runs simulations to determine whether you are saving enough during your working years and how much you can expect to be able to draw in income during retirement.
The approach, called Monte Carlo simulation, is the standard for this type of calculation. There are some nuances to this specific tool that need to be specified. First, the tool assumes that there are three asset classes in the world: stocks, bonds, and short-term bonds. A portfolio can only be allocated between these three classes. The tool further assumes an annual expense ratio that is typical for these classes of funds. The average expense ratio for a stock fund is assumed to be 1.2% per year. I believe this is a decent estimate, but you can do a lot better. The Vanguard S&P500 fund, VFINX, has an expense ratio of 0.18% and you can get even lower expenses if you go with ETFs.
The tool has the built-in assumption that stocks will return an average of 10% per year, bonds 6.5%, and short-term bonds 4.75% (before expenses). These assumptions have a major impact on the amount you need to save and how much income you can draw. Lower expected returns would mean that you would need to save more/work longer/draw less income. Many–including me–argue that the assumptions about future returns are on the high side. Realistically, is there any basis for believing that ‘stocks’ will return 10% a year on average?
For those who have not used a probability-based tool before, the results are likely to be sobering. A quick test suggests that a person retiring at age 65 today with $1 Million invested would plan on drawing only about $40,000 in income the first year, and escalating that amount upwards at a rate of 3% per year to keep pace with inflation. This result is pretty consistent, whether you have 90% of your assets in bonds and 10% in stocks or 40% of your assets in bonds and 60% in stocks. The model is suggesting that more aggressive allocations increase your return and risk proportionately, so that you don’t actually improve your situation by being more aggressive. This result is the one thing about the RIC tool that does not seem right: you can invest 100% in bonds and you have almost exactly the same amount of sustainable retirement income as a 60% stock / 40% bond portfolio. If that’s the case, why would retirees invest in stocks at all?
You can play with the results to see how changing the inputs impact the results. Retiring later helps a great deal. You can see how much more you might need to save in order to reach your goals, too. A range of research that I am familiar with suggests that asset allocation does matter quite substantially in determining how much you need to save and how much income your savings can provide, but RIC does not appear to capture these effects (as noted above). To really explore asset allocation, a more sophisticated tool will be required.
The RIC tool is not a comprehensive planning tool–nor is it designed to be. That said, RIC is a well-designed tool that is consistent with standards of practice in this area. If you want a free 5-10 minute checkup, this tool is very good. Needless to say, this tool is not a ‘robotic advisor’ and should not be interpreted as advice–as the disclaimers clearly state.