Most entrepreneurs have a dream of life after 65: palm trees, grandkids and golf.
But in the era of 401(k)s, a small business person’s own investment acumen can make the difference between Pebble Beach and putt-putt.
The Internet has helped democratize financial planning. Sites such as Morningstar.com, Bloomberg.com and MSN.com’s Money page feature retirement calculators capable of assessing future net worth in a few clicks. But there are an awful lot of calculators out there. How do you decide which one to use?
When retirement anxiety first sends you to the Web, it’s tempting to plug your savings plan into the simplest-looking calculator available.
At Quicken.com, for example, you can type in basic financial information, confirm a few pre-set predictions of economic performance, and estimate the annual income you hope to enjoy after retirement. You’re presented with an ominous red, cautionary yellow or cheerful green light telling you whether your plan will work.
These types of calculators “are good as a starting point, to get some realistic expectations about what retirement will cost,” says Terrence E. Herr, a co-founder of Herr Capital Management LLC in Chicago. “People who come into my office, who’ve done it, have pretty realistic ideas about the amount of money it’s going to take to retire.”
But that green light can promote a false sense of security. A number of assumptions underlie any retirement calculator’s assessment. The simpler the format, the more assumptions will be made.
First, consider taxes.
Only 8% of online advice tools take taxation into account, according to the report from Cambridge, Mass.-based Forrester.
If the program you’re using isn’t one of these, it’s going to present an unrealistic picture.
“If you’ve got your money in a 401(k) or an IRA, these are tax-deferred vehicles. These are not tax-free vehicles,” says Tonja E. Sepulveda, vice-president of Chicago-based brokerage firm Marc J. Lane & Co. “You’ve got to factor in that somewhere down the line, there’s going to be tax consequences. One calculator I went into had nothing in respect to that.”
Then, there’s the question of economic outlook. Most calculators estimate rates of inflation and returns on investments based on past performance. You can often input your own estimates, but then your assumptions may trip you up. If you’re counting on the market to perform as it did in the 90s, you’re likely in for a rude awakening.
“Fifteen years ago, people were using inflation rates approaching the double digits. Now, we’re using inflation rates of two, three, four percent,” says Eileen B. Trost, a partner specializing in estate planning at the Chicago law firm Sonnenschein Nath & Rosenthal. “Same with earnings. Three or four years ago, people were looking at rates of returns on investments of 15% to 16% a year. Now, they’re looking at 4%.”
Some programs work negative assumptions into their return estimates, projecting low earnings for some years and high earnings for others. These assumptions usually don’t take your portfolio’s composition into account. They’re based instead on the past performance of the market as a whole.
“(Most retirement calculators) do not help you really understand, or quantify, investment risk,” says Christopher Jones, executive vice-president of financial research and strategy for Palo Alto, Calif.-based Financial Engines Inc., which produces software to help employees manage their 401(k) investments.
Most calculators, Mr. Jones notes, assume the user’s portfolio consists primarily of zero-cost index funds. If you invest in individual securities, your exposure to particular sectors will affect your projected rate of return.
One antidote is to employ a program like Morningstar’s Portfolio X-Ray, which breaks down mutual funds to show how your portfolio is balanced between different market sectors, small- and large-cap stocks and value vs. growth stocks.
Morningstar also offers comparatively sophisticated projections depicting a range of possible performance outcomes.
In the end, the best solution to the dilemmas retirement calculators can present is common sense: Educate yourself. The better you understand your unique financial situation, the more control you’ll have over any tool you use.
–Crain’s Chicago Business