A few testimonials...

From Art Kingsley, Leonardtown, MD: “I have used a number of PC-based financial planning software packages, some free, some at a cost. By far, PRC offers the best value and capability! You get what you spend with most free calculators. Not only does PRC calculate a standard of living based on accurate expense and income calculations, its output is fully transparent, easy to follow, and verifiable. If you don’t want to verify, rest assured complex calculations are being correctly applied. You can start with a simple model and add complexity as you go along. With its historic analysis capabilities and superior input and output interface, the Pralana Retirement Calculator now far exceeds the more expensive ESPlanner.  Its capabilities are truly immense.”

From Dwayne C, Gardner, MA.: “I love this program…so powerful yet fairly easy to use. It has made our retirement planning much more a plan as opposed to a guess. I’ve endorsed it on Darrow Kirkpatrick’s website as well as with friends and relatives.  And frankly, this is without a doubt the best $100 I have ever spent…for the price of a nice dinner out, getting to see where you’ll stand financially in the future based on where you are today…it really is a great bargain.”

From Bryan D., Chicago, IL: “PRC is very powerful and easy to use financial planning software. I have tried many other financial planners (including ESPlanner) and for my purposes PRC is the best! PRC allows you to quickly enter your income, expenses, and assets to see a year-by-year projections of future cash flow, taxes, savings, and net worth. It has very robust calculations including factoring in inflation, taxes, social security, and life insurance.  It allows you to quickly change assumptions (e.g. inflation, life expectancy, tax rates) and view different scenarios. I really like the analysis page that graphically shows three different scenarios side-by-side. I highly recommend PRC.”

Here’s an in-depth, qualitative and quantitative comparison of over a dozen retirement calculators.  Read on...

Calculator Evaluation list:

Pralana Retirement Calculator

ESPlanner

Flexible Retirement Planner

FIRECalc

Ultimate Retirement Calculator

SmartMoney Retirement

T Rowe Price Retirement Income

AARP Retirement Calculator

MSN Money Retirement Calc

Charles Schwab Retirement Calc

Vanguard Retirement Income

Vanguard Nest Egg Calculator

Fidelity Retirement Income Planner

With PRC2015/Gold, you can:

Analyze 3 independent scenarios simultaneously using fixed rate, Monte Carlo and historical analysis methods

Model key assumptions, complex income streams, investment assets, property expenses, education expenses, healthcare expenses and discretionary expenses

Start simple and add complexity anytime you wish

Perform a complete life cycle analysis with consumption smoothing, life insurance recommendations and survivor scenarios

Keep synchronized copies on your home computer and your office or travelling computer

Getting beyond the fluffy rhetoric on the subject of retirement calculators

This is the first of several top-down technical articles on retirement calculators.  It has been prepared by the designer of the Pralana Retirement Calculator but it is written objectively and will not get into the highly subjective business of suggesting “the best retirement calculators”.  Armed with the knowledge presented in this article and others to follow, you will be equipped to assess for yourself the goodness of a retirement calculator and the extent to which it can be trusted to provide accurate and/or useful information, and then determine which one (s) might be “best” for YOU.  

This first article works its way into the subject matter from a very high level and starts the process of peeling back the skin of a retirement calculator.  The second article will peel that skin back all the way and explore the effects of various design choices on a calculator’s outputs.  The third article will address some advanced topics and hopefully facilitate your efforts to get the most out of a retirement calculator.

Retirement Calculators 101 (The formula for creating a prognosis)

Retirement calculators are about one fundamental thing: they create a long term prognosis of your financial health based on certain assumptions and then allow you to change some or all of those assumptions to observe the effects on that prognosis.  Here, in the simplest mathematical form possible, is the formula for creating that prognosis:

Long term prognosis = initial savings + growth of savings + deposits to savings – withdrawals from savings, projected out over your lifetime. The terms of this formula are defined as follows:

  • Initial savings is the amount of money currently in your accounts.
  • Growth of savings is the interest and dividends earned on your accounts and the growth (or loss) on the investments you’ve made with your money.
  • Deposits to savings are the new money that will be added into your accounts in the future, including the liquidation of real property.
  • Withdrawals from savings are the money taken out of your accounts to cover negative cash flows whenever your expenses exceed your income.
  • Projections are the year-by-year additions to and subtractions from your savings for some number of years to create the long term prognosis.

Retirement Calculators 102 (Defining the terms comprised by the prognosis formula)

Growth of savings is often referred to as “rate of return” and is always expressed as a percentage.  This percentage is then used to determine how the value of the savings accounts change each year, independent of any new contributions or withdrawals.  For example, if the growth is 5%, then the size of the account at the end of year 2 will be 105% of what it was at the end of year 1 (ignoring the effects of inflation).

Your income, which is indirectly affected by inflation, includes wages, salaries, pensions, Social Security benefits, annuity payments, contributions made on your behalf by others (such as company-matching on your 401k contributions), windfalls such as inheritances, life insurance, or the selling of your home.  Your expenses, which are usually directly affected by inflation, are every dime you spend, including payroll deductions, taxes, down payments on new property, house payments and utility bills, car payments and maintenance, gasoline, healthcare, college educations, food, clothes, vacations and so on.  The difference between your income and your expenses determines whether you’re making deposits to or withdrawals from savings.  Let’s call this difference ΔIE (delta IE, where delta refers to difference,  I refers to income and E refers to expenses).  When ΔIE is positive, you have a net deposit in the amount of ΔIE; when ΔIE is negative, you have a net withdrawal in the amount of ΔIE.

To create the projection of your savings, the retirement calculator simply has to do the following:

  • adjust the savings balance each year by multiplying the final balance of the previous year by the expected growth percentage in the subsequent year
  • make annual adjustments to both income and expenses to account for inflation and other time-related changes
  • determine ΔIE and add it to the growth-adjusted savings balance (note: adding a negative number is, in effect, subtracting)
  • repeat the above steps for every year of your life expectancy

Retirement Calculators 201 (Growth of Savings)

For the sake of this discussion, let’s say that savings accounts come in the following forms:

  • checking or savings accounts that may  generate some amount of interest which is taxed as regular income
  • investment accounts may grow or decline over time depending upon how the underlying investments perform and the growth is taxed as capital gains when withdrawals are made
  • tax-deferred retirement accounts (which may grow or decline over time depending on how the underlying investments perform), such as 401k’s and traditional IRA’s, which are funded with pre-tax money and are untaxed until withdrawals are made, and then taxed as regular income
  • tax-free accounts (which may grow or decline over time depending on how the underlying investments perform), such as Roth IRA’s, which are funded with after-tax funds and whose growth is never taxed

There are some issues that arise when trying to model these savings accounts in a retirement calculator:

  • How does a user specify savings account growth?  Is it done separately for each of the major categories of accounts as suggested above, or is an average across all accounts used?  Is the same growth rate used every year, or is it somehow nuanced over time to reflect changing investment mixes?  Does the user have direct control over the annual growth rate, or does the calculator ask the user to characterize the type of investments involved and then use historic average rates of return?
  • Is some mechanism employed in an attempt to simulate the year-to-year variations always experienced in real world investing?
  • How are taxes handled on the simple interest generated by these accounts and on the capital gains realized whenever withdrawals are made?  How are taxes handled when withdrawals are made from tax-deferred accounts?  What about the handling of Required Minimum Distributions and penalties on early withdrawals?

The answers to the above questions have a direct bearing on the complexity of the calculator and on the complexity of the calculations the user has to perform just to make reasonable inputs to the calculator.  All of this will be addressed further in the next article.

Retirement Calculators 202 (Calculating ΔIE)

Calculating ΔIE, which is income minus expenses, is a simple thing once annual income and annual expenses are known; however, defining income and expenses involves some complexities and this is where we can find significant differences in the approaches used by the designers of retirement calculators.

As previously stated, your income includes wages, salaries, pensions, Social Security benefits, annuity payments, contributions made on your behalf by others (such as company-matching on your 401k contributions), windfalls such as inheritances, life insurance, or the selling of your home.  One way or another, every retirement calculator must collect information from the user related to the various income streams and create an “income profile” that projects the user’s income into the future, including annual adjustments as appropriate.

As also previously stated, your expenses are every dime you spend, including payroll deductions, taxes, down payments on new property, house payments, healthcare, and college educations.  One way or another, every retirement calculator must collect information from the user related to the various expense streams and create an “expense profile” that projects the user’s expenses into the future, including annual inflationary adjustments as appropriate.

Expense streams and, to a lesser extent, income streams, tend to be more complex during the accumulation phase than in the distribution phase because they include things like fixed rate mortgages which eventually get paid off, child-rearing/education expenses which taper off as the kids leave the nest, and company matching on contributions to 401k’s.  To avoid this complexity, a common design choice is to treat the accumulation phase differently than the distribution phase.  In this case, the calculator will not create income or expense streams during the accumulation phase and will instead simply ask the user to tell it ΔIE, (i.e., savings contributions during your working years).  Armed with this number, all the calculator has to do is adjust it for inflation (or not) and add it to the growth-adjusted savings balance each year throughout the accumulation phase to create that portion of the calculator’s long term projection.  Because the central focus of most of these tools is the retirement (or distribution) phase rather than accumulation phase, the vast majority of retirement calculators use this approach.

Moving ahead into the distribution phase, all retirement calculators actually perform the ΔIE calculation and use the user’s income- and expense-related inputs in doing so; however, there are large variations in the approaches used by retirement calculators in collecting these inputs.  Approaches for collecting income vary from asking the user to specify Social Security and pension income to allowing the user to define multiple income streams for both husband and wife, including part-time employment or self-employment, Social Security, multiple pensions, annuities and windfalls.  Approaches for collecting expenses range from asking the user to specify a single number representing total expenses for all time (commonly specified as a percentage of pre-retirement income) to specifying the details of a large variety of expense streams with variations over time, such as property, child-rearing, healthcare and discretionary expenses. 

Retirement Calculators 203 (Taxes)

A complicating factor intentionally omitted from the discussion on calculating ΔIE is taxes, specifically income and FICA taxes.  Taxes are an expense, but there is no standard way for treating taxes in the world of retirement calculators.  Here are some of the approaches in use:

  • Ignore them (often with some corresponding text to try to persuade the user that taxes don’t really matter)
  • Ask the user to specify a tax rate and use that to simulate the effect of taxes on income and savings growth (some allow separate tax rates for income and savings growth), which naturally requires the user to determine and enter the correct tax rate(s).
  • Ask the user to specify a tax rate that applies to withdrawals from savings while asking that same user to specify net (post tax) income rather than gross income. This also requires the user to determine and enter the correct tax rate and, further, to use that value to manually convert gross income to net income prior to entering it into the calculator.
  • Perform detailed tax calculations and ask nothing of the user

This disparity in the handling of taxes is one of the reasons why you can observe very different results from various calculators to seemingly the same input data.  The next article will clearly explain why the different approaches yield different outputs and quantitatively address the sensitivity of long term projections to errors in tax calculations.

Retirement Calculators 204 (Keeping track of your savings)

As a quick review, we’ve now discussed the growth of savings and the calculation of deposits to and withdrawals from savings, including the effects of taxes.  Let’s now turn our attention to keeping track of your savings as it grows or declines and as we make deposits and withdrawals.

If the calculator treats all savings as one common pool and simply doesn’t try to model the unique characteristics of separate types of savings, then all it has to do is add annual ΔIE to the old balance to get the new balance.  A subset of these calculators recognize that withdrawals from savings can be a taxable event and apply a tax burden on all withdrawals based on the user-supplied tax rate.

The calculators that manage the various savings accounts separately must deal with considerably more complexity than those that model savings as a single pool of money. In these calculators, a positive ΔIE is probably treated as a deposit to regular savings but when ΔIE is negative these calculators must determine which account to take the withdrawal from.  The order in which withdrawals are taken across the various savings types may or may not be under the user’s control.  A common approach would be to take it from regular savings first and when that’s depleted, then go to either tax-deferred or tax-free accounts to cover the deficit.  In any case, the calculator must establish the order in which withdrawals are to be taken whenever negative cash flow (negative ΔIE) situations occur and it must work its way from one account to the other whenever the withdrawals result in the depletion of one or more of the accounts (possibly when negative ΔIE is large and prolonged over several years).  When this process results in withdrawals from tax-deferred savings, this is a taxable event which in turn affects expenses.  When this process results in withdrawals from regular savings, this may be a taxable event with an attendant effect on expenses.  It depends upon whether the growth of the regular savings is taxable as simple interest/dividends (taxable annually as the growth occurs) or taxable as long term capital gains (taxable only when withdrawals are made and then only on the growth and not on the principle).  Some calculators have the capability to fully model this while others always assume growth is to be treated as simple interest.

Calculators that keep track of the balance of tax-deferred accounts typically also deal with the issue of Required Minimum Distributions (RMD’s) and automatically generate taxable withdrawals starting at age 70 or 71.  These RMD’s can be treated as additional income or as additional deposits to regular savings.  Regardless, the RMD’s must be accounted for in the process of keeping track of the balances of the various types of savings accounts. They matter because they’re a taxable event which has ramifications on annual expenses.

So, here’s a simple question to ponder: Presumably there are financial advantages and disadvantages to regular accounts vs. tax-deferred accounts vs. tax-free accounts and it makes a significant enough difference for us to employ different accounts in preparing for retirement; otherwise, we’d just put all our money in one account and not worry about it.  Does a similar consideration come into play when it comes to modeling our savings over time in a retirement calculator?  Does trying to model the complexity described above actually matter when it comes to a prognosis of your financial future?  Think about it and we’ll come back to it in the next article.

Coming soon...

Retirement Calculators 301 (Sensitivity of Long Term Projections to Simplified Accumulation Phase Modeling)

Retirement Calculators 302 (Determining Retirement Income Requirements)

Retirement Calculators 303 (Sensitivity of Long Term Projections to the Tax Handling Approach)

Retirement Calculators 304 (Sensitivity of Long Term Projections to Pooled vs. Separate Savings Accounts)

Retirement Calculators 305 (Ease of Use Issues)

Retirement Calculators 306 (Analysis Methods)

Retirement Calculators 307 (Unknowns, Cautions and Risks)

Retirement Calculators 401 (Consumption Smoothing)

Retirement Calculators 402 (Personal Finance/Life Cycle Models)

 

 

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