Main User Input Area
This section describes each of the program inputs as well as the underlying assumptions and subtleties of how inputs are handled by the planner.
Current Age matches the current calendar year with your age when displaying results. Current age is also used to compute when in the plan you are eligible to receive penalty-free withdrawals from your retirement accounts.
Retirement Age is used to determine when the savings part of the plan ends and the retirement (spending) part of the plan begins. The annual savings that you enter on the main input panel stops once retirement age is attained. Also, if you selected the flexible spending policy, the retirement age that you specify determines when in the plan to begin applying the policy. Finally, the value that you specify on the main input form for Annual Retirement Spending will be deducted from your portfolio (with adjustments) each year once retirement starts.
Life Expectancy is used along with current age to determine how many years to model in your retirement plan.
Inflation & Taxes
The fields in this section allow you to specify inflation rate and tax rates that the simulation will use during your plan.
Inflation -Avg and Inflation – Std Dev can be used to specify the average rate of inflation and the standard deviation of inflation during the simulation. For each run of the simulation, each year’s inflation rate is randomly drawn from a normally distributed pool of possible inflation rates (this is done by using the Box-Muller transformation).
There is some research to indicate that specifying a non-zero standard deviation for inflation may be counter productive because of statistical issues in tracking the correlation between inflation and portfolio returns. If you are unsure what to do with this value, please leave it at zero.
Note that no attempt is made to correlate a given year’s inflation rate with prior years’ inflation rates or with corresponding portfolio returns. Some may view this as a significant weakness of the simulation, however, the historical record indicates that correlations in this area tend to be unsteady at best.
The Investment Tax Rate determines the rate at which each year’s portfolio gains (from taxable investments) will be taxed. The simulation assumes that taxes on all gains in the taxable portfolio are paid in full each year and no taxes are deferred. This assumption will be incorrect in the case of a low turnover portfolio or when a plan starts out with a significant amount of deferred gains in taxable accounts. To compensate for these cases, it may be necessary to reclassify some percent of taxable investments as tax deferred investments or to run some experiments with different investment tax rates to see how sensitive the plan is to this input. Also, taxes are “credited” to the portfolio (instead of debited) in years where the portfolio return is negative. This is to prevent double taxing gains as the portfolio value fluctuates.
The Income Tax Rate is used to compute taxes due on withdrawals from tax deferred investments during the plan. See the documentation section on Additional Inputs for details on how to represent changes you expect in the income tax rate over the course of the plan.
Another way to think about how the tax rates apply is to consider the “phase” of retirement. During the accumulation phase of the plan (before retirement) the gains on the taxable portfolio are taxed each year at “Investment Tax Rate”. Next, during early retirement, before required minimum distributions (RMDs) are started, the gains on the taxable portfolio are still taxed at the investment tax rate, but any withdrawals from the tax-deferred portfolio are taxed at “Income Tax Rate”. This rate also applies to taxable retirement income. Finally, during late retirement, if the option to take RMDs is selected, these will be taxed at the “Income Tax Rate” then used to pay current expenses. In any year when the after tax RMD is greater than the expenses for the year, the difference is rolled back into the taxable portfolio, which continues to have its gains taxed each year at the investment tax rate.
Starting Portfolio Balances
Investment portfolio balances are broken into three categories, Taxable Investments, Tax Deferred Investments, and Tax Free Investments. Each year, the taxable investment balance is adjusted for taxes based on the investment tax rate. Tax deferred investments (such as regular IRAs and 401Ks) are not assessed annual taxes, but are taxed at the income tax rate when they are withdrawn. Tax free investments (such as Roth IRAs or 401ks) are not taxed at all in the simulation.
The Min IRA/401k Withdrawal Age input controls the minimum age for penalty free IRA/401k withdrawals. If any withdrawals are required from tax deferred or tax free accounts before the minimum age is attained, income taxes and a 10% penalty are deducted from the withdrawals.
Expected Annual Savings
Expected annual additions to your investment portfolio are specified in the fields Taxable Annual Savings, Tax Deferred Annual Savings, and Tax Free Annual Savings. These amounts are assumed to automatically increase each year to keep up with inflation. Note that the simulation doesn’t consider pre-retirement income or pre-retirement spending amounts. You should only enter the amount of net savings that you plan to have each year until you retire.
Investing Style, Portfolio Return, and Volatility
The simulation uses the Investing Style that you choose to determine the average return and volatility that your portfolio balances may experience throughout the years of your plan. When you select an investing style, corresponding values for Return – Average and Return – Std Dev are also set. The average return is a nominal return and both of these values are based on historical results for the selected portfolio type. For additional flexibility, you can set the investing style to Custom and manually specify the average return and standard deviation.
To demonstrate the importance of volatility on a retirement plan, try this experiment. Set the investing style to “Custom” and choose a value for “Return – Average” that you’ve used in other planners (for example 8%). Next, set the “Return – Std Dev” to zero and run the simulation. Note the results this produces then increase the “Return – Std Dev” by a few percent and rerun the simulation. Do this a few times with slight increases to standard deviation each time and notice how increased portfolio volatility (higher standard deviation) affects your plan. This exercise should demonstrate that risk matters. This is why a portfolio’s risk level or expected volatility must be taken into account in retirement planning.
In addition to experimenting with volatility, it’s also recommended that you experiment with different values for average return. You will see that small changes to either of these inputs can have a dramatic impact on your plan’s chances for success. No one can know for sure what returns will be in the future, but at a minimum, success requires that you keep your portfolio well diversified across a wide range of asset classes and carefully manage your investment expenses. Doing so is the best way to maximize your portfolio’s expected return while minimizing its expected volatility.
Finally, when experimenting with different portfolio returns and standard deviations, it’s important to review the Average Spending Shortfall output after running the simulation (see output documentation for more info). More aggressive portfolios may result in a higher probability of success, but they often do so by increasing the magnitude of the failures that occur. The average spending shortfall percent gives an indication of the severity of the shortfall in those cases where the plan fails.
Retirement Spending and Income
This tool is fundamentally different from most other retirement planners in how it models retirement spending through the implementation of a retirement portfolio “Withdrawal Policy”.
The withdrawal policy, or really spending policy, allows the simulation to account for the natural human tendency to make adjustments when things aren’t going as well as expected, or when things are going better than planned. This section will focus on the input variables and leave the detailed description of spending policies until later.
The first input in this section is the Annual Retirement Spending (in current dollars) that needs to be funded during the retirement years. The value specified here should not include amounts needed for payment of income taxes on retirement income or investments since these are calculated and deducted automatically.
The Annual Retirement Income value and the Retirement Income Start Age provide a way to specify any additional sources of funds that will be available during the retirement years. These might include social security, pensions, annuities, or other income that is anticipated during retirement. This income is assumed by the simulation to be taxable and has income taxes deducted from it before it is used to defray the amount needed for annual retirement spending. Also, this amount is given in current dollars and is assumed to adjust each year for inflation.
Next, the Spending Policy determines how annual retirement spending is to be handled. Spending Policies are described in the next section.