One of the most difficult challenges when saving for retirement is determining how much you need to save. One simple method is to create your expected retirement budget and then work backward to figure out how much you need to save. However, this strategy is not necessarily the most accurate because it does not take compound interest into account.
As a result, especially during the early years of saving, it can be difficult to determine whether you are on track to reach your retirement goals. Projecting your retirement savings based on current practices can give you a sense of whether or not you need to make adjustments. Forecasting progress is an important skill that everyone should develop.
This is what you need to know about projecting your retirement savings:
The Art of Projecting Retirement Savings
When you project your savings, you can proactively recognize and address any shortcomings. Identifying these issues as early as possible means more time to save as well as more time to adjust your strategy. Waiting too long to start saving, or failing to evaluate your current savings strategy can put you at a disadvantage down the line. Luckily, learning how to project savings is a learnable skill that you can master with a bit of diligence.
The process of projecting your retirement income involves considering three different data points. Any future retirement balance is a function of how much money is already saved, expected future contributions, and rate of return. Just as with the process of creating a retirement budget and working backward, there is some guesswork involved. For example, you will need to think about how your contributions might increase in value over time. You should also account for employer contributions or deposits from other sources.
The most challenging aspect of projection is predicting the rate of return on your investments. Numerous compound interest calculators are available online. Just plug in your current balance, anticipated future contributions, and desired timeline. This enables you to experiment with a variety of possible scenarios. However, these calculators will require you to predict a rate of return, which can depend on the markets and how money is actually invested.
A Critical Approach to Projecting Returns
Projections that look at least 10 years in the future typically use long-term historic averages to predict the rate of return. All investors know that historic returns are no guarantee of future results. These averages tend to be fairly accurate representations of what you can expect from the market. Historically, for example, the S&P 500 has grown about 10 percent annually, over very long periods of time. However, the markets also experience occasional long periods of underperformance ( “a lost decade” ) as well. For example, the S&P 500 Index was essentially flat from January of 2000 to march or 2013, a period of 13 years and 3 months!
At the same time, the rate of return also needs to account for inflation, which hovers around 3 percent annually, on average. By combining these two numbers, you arrive at an average, inflation-adjusted rate of return of about 7 percent, at least for large-cap stocks. This estimate is a useful starting point, but you should be aware that it may not come to fruition. Testing a variety of scenarios will help you create appropriate contingency plans.
You need to carefully consider your investment vehicles since not all investment classes have the same rate of return. A portfolio that consists of half stocks and half bonds needs to account for the lower rate of return of government bonds. Before inflation, bonds offer about a 5.5 percent return. An adjusted average return for the portfolio described above would be closer to 5 percent than 7 percent.
Higher returns or a “smoother ride” are possible if you invest in additional asset classes, such as precious metals, natural resources, real estate, foreign bonds, and stocks, etc.. However, projections for these investments may be inaccurate because they are so often volatile. You could earn less than the average or even lose money, as you can with the more well known or traditional asset classes. You may want to test a variety of asset allocations and retirement ages to determine how to maximize your savings efforts.
Common Mistakes When Projecting Retirement Income
Once you start crunching the numbers to see where you stand, you should be aware of some of the common mistakes people make when projecting their income in retirement. The most problematic issue is predicting the rate of return too optimistically. Because interest compounds, plugging in a rate that is too high can give you a false sense of security.
Another common mistake is including contributions from an employer that are not fully vested. If you are unsure about your future with a particular employer, you should not include any unvested contributions in your calculations. Many people chose not to include this money at all until it becomes vested.
You also need to remember that these projections are just predictions, and will not mirror reality exactly. The market can be erratic, which means that projections are not always accurate. As a general rule, longer timeframes are more accurate because they look beyond short-term market fluctuation.
You should think of projection as a tool for figuring out how to address any identified shortcomings. Once you have plugged all the numbers into the calculator, you can start experimenting with the parameters to figure out how to reach your goals. For example, perhaps you choose to save an extra $1,000 or more per year, or increase your expected return by investing in more volatile—and therefore potentially more lucrative—investment vehicles. However, increasing your contributions is less risky than investing more aggressively.