A Plan to Make Retirement Calculators More Useful

Dartboard or online retirement calculator? At the moment, either method would work equally well for preretirees who want to figure out how much money they need for retirement or can spend once in retirement.

But all that may change if Francois Gadenne, the founding chairman of the Retirement Income Industry Association and CEO of Retirement Engineering, gets his way.

Gadenne and his group, which includes some of the retirement industry's leading visionaries, last month laid out a statement of principles designed, as one trade publication put it, to "civilize the wild, wild world of retirement income projections."

At present, RIIA and others generally agree that no two online retirement calculators produce the same output, even when the input is the same.

In some cases, the retirement calculators use different underlying assumptions — one may use 3% for the long-term inflation rate while another uses 5%. In other cases, the calculators have limitations of one sort or another — one may use 1,000 Monte Carlo simulations and another may use 20,000.

"It's a little disconcerting that there are a number of tools that give different answers to the same input," said Richard Fullmer, a senior portfolio strategist at Russell Investment Group as well as the volunteer chair of RIIA's principles committee. "It doesn't feel right."

Given the confusion that could arise on the part of preretirees and retirees who use these calculators, RIIA wants developers of retirement income calculators, tools and illustrations to adhere to a set of standards.

RIIA doesn't necessarily want developers to build one calculator that is all things to all people. Rather, it wants developers to build calculators that are right for all people. "We are not trying to tell them how to build it or what to focus on," Fullmer said.

But if they were to focus on one thing and only one thing it would be "disclosure." Few, if any, calculators reveal how the engine under the hood works. Few, if any, calculators reveal what assumptions are being made and why. And if they do disclose, it's hardly in language the average person could understand.

"The thing most in need of fixing is disclosure," said Fullmer. "Users need to know what the calculator is telling them and what it is not telling them."

It's one thing for a calculator to tell a preretiree to save more. It's a whole other matter when calculators start recommending that the preretiree invest more in stocks to reach their goals without revealing the risk that comes with the potentially higher return.

"If all you care about is maximizing the probability of success then you are looking only at half of the equation," Fullmer said. Besides giving the probability of success, the best-case calculators would also disclose the probability of failure. "If you increase the probability of it working, you also increase the magnitude of times it could fail."

RIIA's standards for retirement calculators:

Regardless of an individual's asset allocation and/or retirement spending, the future is inherently random and unpredictable. Probabilities and statistics are the natural language for explaining this randomness and uncertainty. Any retirement income projection illustration should disclose its assumptions such that readers can gauge its reasonableness for a particular purpose.

That is, two varying sets of assumptions and corresponding outcomes may both be valid since the purpose of the illustration may be different in each case. Various mortality tables and longevity forecasts may be suitable for retirement income demonstrations, although others may not be suitable. The relevant methodology used should be clearly disclosed along with an explanation of the suitability of the selected method.

Inflation is neither a universally constant nor uniformly measurable. Different individuals experience different inflation rates, especially as people age. Those modeling inflation over long periods of time should take into account that an individual's cost of living will be different from aggregate measures of inflation such as a consumer price index. The technique and methodology known as Monte Carlo simulation will only provide reasonable results when a large number of trials are generated.

Output should strive to convey the various components of risk rather than selectively focusing only on certain components. The probability of success or failure is only one component of risk; the magnitude of potential failure is another. Illustrations should strive to make these components of risk understandable to the general public.

The yield curve (also known as the term structure of interest rates) is a dynamic and complex economic process. It is not reasonable to model interest rates as constant and flat over long periods of time. The precision with which output is shown should avoid conveying a misleading degree of accuracy in the model.

General acceptance of the industry's models and illustrations depends on individual investors' ability to understand them. Consistent use of terminology and explanations is beneficial and necessary so that the public may compare the output of the many different models that are available to them and establish a level of comfort in interpreting it. The use of wording and illustration should be appropriate for the audience to which it is intended.

So what do experts have to say about RIIA's statement of principles? In general, they praise RIIA's efforts but they also say that wholesale acceptance may be more vision than reality at the moment.

For instance, John Ameriks, principal in Vanguard's Investment Counseling & Research group, and Christine Fahlund, vice president and senior financial planner at T. Rowe Price Group, Inc., both agree with the thrust of RIIA's principles.

And Fahlund — as a financial planner — said she especially likes the principle No. 8. "Monte Carlo analysis is all about ranges of outcomes and probabilities," she said. "Results from these calculators should get you in the ballpark for knowing what strategy to adopt to achieve your retirement income goals."

Ameriks, however, said RIIA's principles, though useful, need to be understood and be put in their place.

"For most end-user members of the public, heavily statistical tools are just confusing, calling into question how the output avoids 'conveying a misleading degree of accuracy in the model,'" he wrote in an email.

Vanguard's calculators, for instance, are designed to give people a sense of the important trade-offs, not provide detailed predictions of the uncertain future, he said. "In that sense, they are useful and reflect the spirit here," said Ameriks.

The bottom line, at least until RIIA's principles become a reality, is this: "Whatever you do, don't assume the answers must be exactly the same," said Fahlund. "That would be unrealistic. Instead, decide based on the information provided with each tool whether or not both results actually get you in the same ballpark for achieving your goals. And certainly if you disagree with a tool's assumptions, try another one, instead."