Retirement Calculators – CAUTION
A chain saw can be a very powerful tool but it can also be extremely dangerous if used improperly. When it comes to retirement planning, retirement calculators can be similarly powerful and dangerous. Based on perceived major weaknesses of commercially available software tools, Kyle Financial Services, Inc. has developed a proprietary cash flow modeling tool for retirement cash flow simulations and asset allocation illustrations. Following is a summary of perceived major weaknesses of commercial tools that led us to develop our own proprietary tool:
1. Failure to adjust asset mix over time to reflect declining risk tolerance with age
The single, greatest weakness of commercial software tools is the failure to allow adjustments to the asset mix over time. Most models assist users in choosing an asset allocation target (e.g. 60% stocks, 40% bonds and cash) based on the user’s time horizon and risk tolerance. The problem lies in the fact that, once you've selected the asset allocation target, such models assume that the target remains constant over your lifetime. This assumption is dangerous because, in practice, most investors reduce their allocations to stocks over time to reflect declining risk tolerance with age. Since stocks generally earn substantially higher returns than bonds over time, failure to reduce the allocation to stocks over time results in unrealistically high assumed rates of return. When projecting cash flows over several years or decades, the effects of such assumption are compounded and can be quite dramatic. Our proprietary model incorporates flexibility to adjust asset allocation mixes over time to reflect declining risk tolerance with age, resulting in a more realistic depiction of returns that are likely to be realized over time.
2. Use of constant growth rate
We all know that markets do not grow at a constant rate. However, many models still simplistically assume that investments will grow at a constant rate over time. The major weakness of such approach is that, if an investor is unfortunate to experience negative markets in the early years of retirement, the constant-growth projection quickly becomes obsolete and the adequacy of retirement capital might be in jeopardy. This problem can be alleviated through the use of “Monte Carlo” modeling by which we can simulate how portfolios might behave under thousands of different market cycles. In doing so, we do not profess to predict the future, but Monte Carlo modeling essentially “stress-tests” your portfolio to gain assurance as to whether your assets can sustain you through thousands of potential market cycles.
3. Use of unrealistic return assumptions and failure to consider investment expenses
When it comes to software tools, many are familiar with the phrase “garbage in, garbage out.” This statement exemplifies the importance of using realistic inputs for any retirement cash flow projection. As mentioned above, when projecting cash flows over several years or decades, the effects of return assumptions are compounded and can be quite dramatic over time. As such, even small differences in rates of return can have a significant impact. Suffice it to say that we have been dismayed by unrealistic return assumptions used by otherwise reputable software providers. Further, many packages completely ignore investment expenses such as advisory fees or mutual fund expenses that have a meaningful impact on net investor returns. Using our proprietary cash flow modeling and asset allocation illustration tool, Kyle Financial Services, Inc. employs reasonable estimates of return and volatility for asset classes based on decades of market history and incorporates investment expenses to reflect real-world costs of investment management.
4. Failure to appropriately account for taxes
Surprising as it may be, many popular software tools do an extremely poor job of distinguishing the tax treatment of various investment vehicles such as taxable accounts, IRAs and Roth IRAs. In some cases, models ignore taxes completely. Kyle Financial Services, Inc. recognizes that, not only are these vehicles taxed differently, but we also suggest that these tax differences have implications for investment policy. As such, our proprietary cash flow modeling and asset allocation illustration tool accommodates taxable accounts, IRAs (including required minimum distributions from IRAs) and Roth IRAs and has the flexibility to incorporate unique asset allocation targets for each of these investment vehicles.