Last month’s article about prices began as a rant about the difficulty of knowing what specific items should cost and how to assess their value. In this month’s article, we’ll look at the “price” of retirement. How much does it cost? Have you saved enough?
As a financial planner I want to know what something is going to cost before I say “yes.” Sometimes this can feel a little embarrassing. I’ll be the first to ask the waiter, “So how much is that swordfish special?” Did you grow up hearing, “If you have to ask, you probably can’t afford it”? I have the excuse that “it’s my job,” but I know that many people experience fear around asking. I’m not the only one who wants to know.
The “price” of retirement
I often tell people, “The question of whether you can afford to retire does not have a yes or no answer.” A retirement plan is a projection of your future needs. Rather than being a fixed number, the cost of retirement is based upon a series of – well, estimates. There are estimates of what you think you will spend, estimates of inflation, estimates of what your investment returns will be, and how long you may live.
Given all these variables, the best we can hope for is to create a plan designed to maximize our chance of success. We gain greater understanding of the main levers at our disposal to achieve this goal. If the total cost of your retirement plan over a thirty-year period is a big number, take heart, because there are a variety of ways to get there.
How Do We Know If We’ve Saved Enough?
So, while there is not a definitive answer to the question, “How do we know we’ve saved enough for retirement?” in financial planning we do have a probability tool that helps us to provide some level of confidence and comfort that things can work out as planned. It’s called Monte Carlo analysis. Despite the gambling connotation, this is simply a means of projecting various scenarios for your retirement strategy.
The program produces a series of numbers, much like the spin of a roulette wheel. It runs the components of your financial plan a thousand times, with randomly generated investment returns to see how many times you have money in the bank at the end of your estimated life expectancy. The result is a percentage of confidence, on a scale of 1 to 100.
I Want More Confidence That I Can Stop Working!
Let’s review what this means. We know that there are two sides to a coin. A coin toss has a probability of being heads 50 percent of the time and tails 50 percent of the time. Most people want the result of their planning to yield results that have a probability of success greater than the flip of a coin. If you couldn’t achieve a better percentage, why bother with planning at all!!
We can’t give a hard and fast number to answer the question of how much retirement will cost. Then the question becomes, “How much ‘confidence’ in having enough money for retirement, based on the projected variables, is enough?” That will be different for everyone.
For example, you might say a confidence level of 80 percent seems pretty good. Recall that in school, 80 percent was a B minus. It means in essence that eight out of ten times the outcome will be as predicted. It also means that two times out of ten your plan could fail. The obvious problem with this is that you don’t get ten tries, you only live once. I usually aim for as high a level of probability as possible, especially for those who don’t have a lot of assets. Those who do have more financial flexibility, and thus “wiggle room,” can work with a lower probability number.
What began as frustration with the lack of precision and predictability about prices generally led to a discussion about an important concept in financial planning – the use of the Monte Carlo process to generate a probability (a number) to provide more confidence that we can live without running out of money.
The “right” answer?
Sure, we want the “right answer,” as if it were a math problem at school. However, with retirement, the best tool we have in our arsenal is the creation of a financial plan to assess what it might cost. Then we can look at the probability that our efforts will be successful. There are many moving parts to retirement that we can’t quantify exactly: investment returns, inflation, healthcare costs, etc. But there are things we can influence, such as how much we spend, save, and invest.
In planning, we focus on what we can do and increase our level of confidence as much as possible. This process provides some comfort in dealing with the uncertainty of the actual cost of our future life. It is certainly a lot better than leaving it to chance and the 50/50 outcome of a flip of a coin.