The engineer in me looks for quantitative signs and analytical answers to the  ”Am I prepared for retirement?” question. Not long ago I presented my own simple way to determine retirement readiness. More recently, Jonathan Pond, a financial writer for AARP, proposed a list of “you know you can retire when” signs and circumstances. (I don’t have a link to share for this.) I found the list simple yet well thought out. Thus, I thought I should share it with readers here, with some brief commentary of my own.

You know you can retire when ….

1. You won’t run out of money until age 95. This is the basic quandary of money and longevity. Some folks rationalize spending with “I have to enjoy life now because I won’t live forever.” If you live to 95 and your money gives out at 85, that last ten years may seem like “forever.” (Here are some resources on life expectancy.)

2. You can wait for Social Security. Much has been written here and elsewhere about the best age to claim Social Security retirement benefits and the downside of claiming before full retirement age. Being in a position to wait means that you can implement the economic concept of “consumption smoothing.” Basically, this concept may cause you to spend more of your nest egg early if necessary to claim Social Security later.

3. You own your home. Living in a mortgage-free home can solve so many different financial problems for retirees. Here are some resources to consider whether you should have a mortgage in retirement. We are mortgage-free with our vacation home (which we will use as a part-time retirement residence) and are moving in that direction for our condo purchase.

4. At least 40% of your income is guaranteed. I actually think this percentage should be a lot higher – 100% actually – for your basic retirement income needs. That’s why I am working on our own plan for guaranteed retirement income. If you have your basic needs met with a pension and/or Social Security, that’s fantastic.

5. You can cut one-fifth of your spending in hard times. I suppose this means that 20% of your spending is 100% discretionary. Perhaps more important is that it means that you are willing to make those cuts when the need arises. Too many people are too proud, too stubborn, or are in denial and wait until it’s too late to make needed cuts. Can’t do that when the income is fixed and the nest egg is shrinking faster than anticipated.

As I said, I appreciate the value of this list. I plan on re-visiting it regularly when evaluating our own retirement readiness.

What about you? Are you looking for signs of being prepared for retirement? What are they?

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I’ve written about many of them here. Retirement calculators are everywhere but mostly on websites where someone is trying to sell you something. Some are complicated, some are simple but based on flawed assumptions. If you are into “simple”, I have a suggestion for a way to determine if you are financially ready to retire.

First, when I say that my suggested retirement readiness assessment method is “simple”, I don’t necessarily mean “quick.” The first step may require a little effort on your part. So here it is:

Step 1: Create a Retirement Spending Plan

All this means is knowing with some degree of accuracy how much money you will need to spend each year when you are retired. You may already have done that math. If not, spend 30 -60 minutes creating a retirement spending plan. Use a budget spreadsheet. If you don’t have one, you can download a free budget spreadsheet from Google Docs. Be as accurate as you can without getting buried in details and pennies. Don’t worry about inflation at this step.

When you are done creating your retirement spending plan, make note of the total yearly spending number. You will need that later.

Estimated time to complete this step: 30-60 minutes.

Step 2: Estimate Your Annual Social Security Income

Find the paper copy of your annual Social Security retirement statement or use the online benefit estimator. Determine what your monthly benefit will be on the date that you retire. Multiply by twelve to obtain a yearly total. Write that number down.

Estimated time to complete this step: 5-10 minutes

Step 3: Total Your Retirement Nest Egg

In this step you add up the present dollar value of all of your investments and other assets that you can use for providing retirement income. These can include CDs, bonds, stocks, mutual funds, 401(k) and IRA account balances, etc. As one example of “other assets”, if you will be downsizing into a less expensive home, this may provide cash when you liquidate your equity. Write the total calculated number down, as you will use it in Step 4.

Estimated time to complete this step: 15 minutes.

Step 4: Annuitize Your Retirement Nest Egg

This is where, for sake of simplicity, we make an assumption: You will use all of your retirement nest egg to purchase an inflation-adjusted, immediate annuity. You won’t actually do this when you retire (although you could) but it gives you some idea of how much retirement income your nest egg can provide, if properly invested. Note that I specifically mentioned annuities that provide inflation adjusted income. This is important because you want your spending power to remain relatively steady throughout your retired life. Social Security has cost-of-living increases. You want your hypothetical income from your retirement nest egg to do the same.

To determine how much retirement income you can expect if you annuitize your retirement nest egg, use an annuity calculator. Vanguard has one of the best here. To make it simple, request the annual income number for a single life with no cancellation option. Be sure to check the “Fixed Income with Inflation Adjustments” box. Write down the annual income number that is generated from the calculator, using the lump sum dollar amount you determined in Step 3.

Estimated time to complete this step: 5-10 minutes

Step 5: Add Income and Compare to Spending

This step is simple arithmetic. Add the annual Social Security retirement benefit determined in Step 2 to the annual annuity income determined in Step 4. This represents your hypothetical annual retirement income that you can expect for your lifetime, adjusted for inflation.

Now compare that total income number with your annual retirement spending that you determined in Step 1. If the income number exceeds the spending number, you may be financially prepared to retire. If the spending number is larger than the income number, you may have some work to do.

Estimated time to complete this step:  5 minutes

Why This Simple Method Works

The two biggest financial concerns for retirees are outliving their income and inflation. This method takes these concerns into account by using income sources that you generally cannot outlive and that are adjusted for inflation. Because inflation adjustments are built into the income estimates, you can use existing spending levels for your spending plan.

Is this method perfect? No it’s not. For example, it may not take into account severe health problems requiring long term care or unusual expenses not accounted for in your spending plan. The correlation between annuity income and investment income from your retirement nest egg is not exact. But this method is simple, is logical, and is better than not knowing what to expect in the way of sustainable retirement income. It can certainly help add some realism to the “am I ready to retire” question.

Give it a try. Let me know what you think.

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The report is not your standard investment performance report. Instead, it hits you in the face with a statement of how likely or unlikely your current investments and contribution levels will generate the retirement income that you have set as your goal. The report also indicates (on a scale compared to other portfolio types) the amount of risk you are taking. Finally, the forecast tells you where your retirement income will come from.

The Financial Engines retirement report methodology is supposedly proprietary. They do tell you that it uses Monte Carlo simulations of thousands of different investment scenarios and outcomes. The income projections are derived from an assumption that you would annuitize all of your retirement investments at your retirement age. You wouldn’t do that of course but it is a logical way to compare different outcomes.

The changes in our retirement income forecast through 2009 were quite dramatic. I selected a retirement income goal based on a retirement age of 62 and a retirement spending plan that was comfortable but neither spartan or luxurious.  I won’t fully retire at 62 but I wanted to know what would happen if I did.

When I first created this plan in 2007, my forecasts consistently exceeded a 95% probability of reaching our income goal. This means of the thousands of simulated economic and investment performance scenarios, our retirement income goal would be achieved in more than 95% of them.  On February 24, 2009 (just before the market turned north), I received an email report that the probability forecast had dropped to 36%! That’s a serious wake-up call to action.

According to my analysis, our best plan of action was to stay invested while increasing cash-equivalent holdings. My next report arrived on May 11, 2009. Now the forecast had jumped back up to 70%. Another retirement forecast report was sent on August 11. The forecast probability has increased again, to 80%.  On November 24, 2009, the last emailed report, the forecast was back ino my comfort zone of greater than 95%. The tool also tells me that 30% of our retirement income will come from Social Security and the balance from our personal investments. No pensions for us.

I can check these forecasts at any time by logging into my account where I can also receive automated advice on portfolio adjustments I could make to improve our odds. I have never used the Financial Engines advice , preferring to scenario test my own portfolios.

I like the Financial Engines retirement income forecast tool. It’s not perfect but watching how investment choices and market conditions affect retirement income predictions certainly keeps me engaged and vigilant.

What tools do you use to forecast retirement income success?

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A smart entrepreneur has started BIDaWIZ. This online service connects consumers and business owners online with personal finance and tax professionals using a unique “I can answer your question for $xx” process. Seriously.

When you need a professional answer to a specific personal finance or tax question, you select the category, ask the question, then wait. Your question is submitted to multiple “wizards” who have been qualified to respond to your question. The wizards are CPAs, CFPs, or other credentialed financial advisors who have been accepted into the BIDaWIZ system. Those wizards who want to answer your question will submit an “Offer of Service which will include the following information:

• Credentials – Education, Professional Licenses, Work experience
• Customer Ratings – Number of questions answered and average rating
• Offer Expiration – Time until offer expires
• Est. Time of Delivery – Estimated time to receive answer
• Offer Amount – Fixed fee for providing service

Note that last part – a fixed fee for the service! How cool is it to know ahead of time exactly what you will have to pay to receive a professional answer to your personal finance or tax question?

To consider your options, you will receive an email notifying you when a bid is submitted. Then it is up to you to select a wizard (or not) and then move on the complete the engagement, all online.

I have not tried the service yet but it has received good reviews from others. If you want to learn more about having personal finance professional bid for your work, check out BIDaWIZ here.

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The new source I found is the financial calculator section of GeriCareFinder.com. It has ten different calculators, each pertaining to an aspect of retirement planning that could be helpful to baby boomers like us. The calculators include:

• a long term care calculator to help you determine how much a period of needing care could cost you in today’s dollars;
• a reverse mortgage calculator that shows how quickly the balance on a reverse mortgage can increase;
• a life expectancy calculator (I have lots of life;
• a retirement income calculator for predicting retirement income from a certain size retirement nest egg.

My two favorite calculators for retirement planning available at this site are:

• a variable annuity calculator that allows you to compare the growth of a variable annuity purchase (including surrender charges) with a more conventional taxable account;
• a retirement savings shortfall calculator that will predict when you will run out of retirement savings based on your age, withdrawal rate, and other factors.

A time-saving aspect of this set of retirement planning calculators is that you can save the work you do in a personal “workspace” just by registering at the site. It’s free. You can even share the workspace with your spouse.

Finally, whatever retirement planning tools you use, be aware of their inherent flaws and shortcomings.

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First, I monitor our net worth weekly. We use Quicken for our financial management and link it to all of our bank, investment, and asset accounts. Merely opening the program and downloading data from our various accounts gives me an instant net worth report. I can chart our net worth over time. This tells me if we are generally making progress with our investing, saving, and spending.

Second, I monitor the total value of our retirement assets weekly. I have our various assets that are designated for generating retirement income organized together so that it is easy to see the total value of those assets as well as our internal rate of return. These assets include our 401(k) account, IRAs, I-Bonds, stocks and mutual funds held in taxable accounts, insurance cash value, and net equity in real estate that we will eventually sell to reinvest for income generation.

None of this is particularly novel or surprising to anyone who is actively involved in their own retirement planning. But I don’t think this is enough. To properly measure progress and provide increased motivation, I think you need to estimate what kind of income your retirement assets will generate. There is a relatively easy and informative way to to do this: I determine how much lifetime income I would receive if I annuitized the lump sum value of our retirement assets.

You can do the same thing. Let’s assume that, like us, you are monitoring and tracking the current market value of your retirement assets. Today they are worth $500,000. You pay a visit to ImmediateAnnuities.com and plug-in that number along with your other relevant personal data. Let’s further assume that you are a 58 year-old male living in Tennessee.  If you purchased an immediate life annuity with no payments to beneficiaries, your $500k would buy you $2,667 in monthly income for life.

It’s not that important which type of immediate annuity you use to track your retirement plan progress. What is important is that you use the same annuity type each time you check. I recommend doing it monthly or quarterly. The result will give you an income-based measurement of your plan progress while also taking into account your age and current market conditions. (The market conditions are generally reflected in the estimate of annuity returns.)

If you want to take this method one step further, you could also compare the annuity income number to a retirement spending budget that you have created and keep updated using current dollars. In other words, assume that in December 2009 the market value of your retirement assets would generate $2,667 in monthly annuity income. Further assume that your budget shows you will need a monthly income of $4,000 in today’s dollars when you retire. This leaves a deficit of $1,333 that will need to be covered by Social Security or other income.  Run the same numbers a year from now to determine if that gap is getting larger or smaller. If the gap shrinks, you are making progress with your plan. If the gap is increasing, you need to consider making some changes to your plan.

This method of tracking your retirement plan progress does not mean that you will annuitize all or even any of your retirement assets. It simply tells you what would happen if you did.  To give you confidence that this is a relevant metric, even respected retirement planning tools like Financial Engines use lump sum annuitization techniques to assess and report the strength and progress of retirement investing.

The bottom line to me is that you must actively monitor, track, and measure how you are doing with the financial part of your retirement planning. Relying on others or on vague assessments without real numbers won’t tell you much.

Do any of you track your progress by these or other techniques?

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Unfortunately, most of these tools have fundamental flaws in them and/or mistakes are made when they are used.

The Pension Research Council has studied some of the better know retirement planning tools and summarized some of the major problems.

The free planning tools tested were:

• AARP retirement planning calculator
• Fidelity Retirement Income Planner
• MetLife calculator
• T. Rowe Price Retirement Income Calculator
• U.S. Department of Labor

These are the major problems found with one or more of the tools:

1. Predicting Plan Longevity. Baby boomers often underestimate how long they will live. The consequence is that they don’t realize long their retirements will be and how long they will need their plan to provide income. (See Life Expectancy and Retirement Planning)

2. Preparing for the Effects of Inflation. While inflation is low now, that won’t be the case in the future. Most retirement planning tools make unrealistic assumptions about a constant future retirement rate or worse, they expect you to predict it. That’s why I think that at least part of your retirement portfolio needs to be protected against inflation. If you use one of the online tools, experiment with different inflation rates to understand the effect on the tool outputs.  (See Inflation and Retirement Investing)

3. Planning for Payment of Medical Expenses. I agree with the Pension Research Council on this: Many retirement planning tools do not properly estimate what our expenses will be for retirement health care. There are tools for that as well and you should probably look at those first, before running a comprehensive planning tool. (See Healthcare Costs in Retirement)

4. Social Security Benefits. A big weakness in some retirement planning software is is either ignoring Social Security entirely or not allowing the user to input a personalized benefit level. This can create plan flaws because Social Security income may be a significant component of your retirement income plan. An estimate of your Social Security retirement benefit is easy to obtain. (See Social Security Retirement Benefit Estimator)

5. Defining Retirement Success. Many online retirement planning tools use their own definition of what a successful plan outcome should look like. Your definition of retirement success may be different. As just one example, you may have a specific desire to leave an inheritance for your children. (I don’t necessarily agree with that but I can understand how others might feel differently. It is important for the user of the planning tool to understand what differences may exist between their ideas for a good plan outcome and what the planning tool assumes.

For more resources on retirement planning tools that I’ve tried or developed, see “Create a Free Financial Plan” (and links therein) and “Creating a Plan for Guaranteed Retirement Income.”

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Let’s take a quick look at the official National Save for Retirement Week website. Right from the front page there is a link to a “Five-Minute Check-up” tool. It’s more like a five-second check-up tool. The first problem I observed was that the tool automatically assumes that your income needed in retirement will be the same as your current income. There are so many reasons why that assumption is flawed. It makes a lot more sense to create a theoretical spending plan and budget for your retirement years. At that stage of your life, it’s all about what you spend, not what you used to earn.

Here are all of the assumptions incorporated into the retirement check-up tool:

1. You will need 100% of your current income in retirement. Not true for most retirees. See above and my post on creating a plan for guaranteed retirement income.

2. You will live in retirement for 30 years. This assumption is OK. If you want to play with the longevity number, check my post on life expectancy and retirement planning.

3.  Inflation will remain steady at 3%. I think this is wishful fantasy. Although the White House is trying to move into deficit control mode, the economy is too precarious to really do anything significant. In a few years, we will be begging for a return to 3% inflation. All the more reason to be thinking about investing for inflation protection.

4.  Your annual income will keep pace with inflation. This is probably not a reasonable assumption for baby boomers. For many of us, the income plateau or even downhill slide has begun.

5.  Your savings will grow at an average annual rate of 8%. I’m not even sure I understand this assumption. If they mean that we can expect an 8% annual return on our retirement savings, who are they kidding? That’s what we thought in 1999, when the Dow first cracked the 10,000 mark.

6.  You will earn an average of 5% annually on your savings during your retirement. This is probably a reasonable assumption as a pre-inflation return. Given present and anticipated future economic conditions, I’m more concerned about the real (inflation-adjusted) rate of return.

7. You will use your employer sponsored retirement savings plan (401, 457, etc.) to save for retirement. Makes sense although there is an outcry from many interested parties that the 401(k) is doomed as a viable retirement savings vehicle for most Americans. A new organization – Retirement USA – is working to completely revamp how we provide for our retirement income. Whatever they are able to accomplish, it’s probably too late for most baby boomers to benefit from it.

I’m curious, readers. How did you fare in the “Five-Minute Retirement Check-Up?”

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The point is to be sure that your advisor is not using a straight line analysis (or equivalent) to calculate the future values of your retirement assets. In a straight line analysis, a constant rate of return is assumed. The actual rate of return may be based on historical data but it is risky and therefore improper and inaccurate to apply that rate of return in a straight line fashion.

There are three fundamental flaws with a straight line projection model. First, it ignores market volatility which can effect portfolio survival. Second, it ignores the order of returns. In other words, a straight line analysis uses an arithmetic mean instead of a geometric mean in applying hypothetical market returns. This is absolutely the wrong thing to do. Third, a straight line analysis does not take into account the possibility that actual market returns will substantially deviate from historical returns.

So what method should your financial advisor use in projecting your retirement income and portfolio survival? One such method is called a Monte Carlo analysis. Using a computer model, a Monte Carlo analysis uses a wide range of projected values for all of your retirement assets. Then, applying historical and theoretical performance data, it projects an overall probability of achieving certain valuation and survival outcomes, at different income withdrawal levels. In other words, your analysis is derived from hundreds or thousands of different scenarios, not a single straight line scenario.

To understand how the different types of analysis can affect the outcome, let’s assume the following: A retiree has a $2 million portfolio in a taxable account. Let’s further assume a 7.8% annual rate of return over 20 years, with a market volatility of 18.3%. From this portfolio, the retiree wants to receive an income of $100,000 annually. A straight line retirement analysis of this data predicts a 100% success rate. Putting this same data through a Monte Carlo analysis predicts an 82% probability of success. Stated another way, the more rigorous and realistic Monte Carlo analysis tells the retiree that 18 times out of 100, his or her retirement income plan will fail. That is important knowledge to have before the plan is actually implemented.

Many financial planners and advisors have access to planning software that will run Monte Carlo simulations of future performance of your portfolio. Make sure yours is one of them. There are also tools that you can use to analyze your own portfolio and calculators for asset allocation strategies. It wouldn’t hurt for you to run the numbers yourself, to be sure that your advisor is not being overly aggressive in an attempt to sell you something you don’t need. Another option is to skip the expense of a financial advisor entirely and use one of the couch potato (“lazy man”) portfolios.

Finally, some experts believe that nothing you can do will sufficiently eliminate stock market risk. They recommend retirement income strategies that exclude the use of stocks and stock mutual funds. I will be writing more about that in the near future.

Photo credit: Tylerdurden1

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Using Google Finance Tools for Free Money Management

I use Google Finance as a one-stop dashboard for monitoring our investments. You can set up one or more portfolios and then customize the data and layout of the portfolio display.  Once you have set up the different investments in your portfolio, Google Finance will automatically compile and display recent news about your investments. Google will also automatically list upcoming events relevant to your different stocks, such as earnings releases. Very cool.

One feature that I like best about portfolio management in Google Finance is that you can enter your actual transactions. That way your portfolio display contains accurate data in real money terms, reflecting a real asset allocation. If you have numerous transactions to enter from other data available to you, you can import them directly into your portfolio using an OFX file. Most spreadsheet and money management software programs can export data to an OFX file. Just look for the “export” utility in your software.

Google Finance has lots of other nice features including some that are brand new:

• Recent quotes for your investments are streamed in real time and are now displayed in the left-hand navigation bar from any page on the site.
• You can now customize placement of sections on your Google Finance homepage using a drop-down arrow on the right side of a section title bar. Click the arrow and  move that section up, down, all the way to the top of the page, or minimize it. This is similar to customizing your iGoogle page.
• Comparing related companies (for stock research) is now easy with an interactive tool. From any company summary page, click “Add or Remove Columns” in the Related Companies section, and add the financial data you are interested in tracking.
• Charting of technical indicators (for you technical analysis investors) is now available. The chart below (courtesy of the Google Finance blog) is one example.

Overall, Google Finance is an excellent resource for assembling and using free investment and money management tools without you having to own or install any software except a browser. By the way, you can also access your Google Finance portfolio from many mobile devices.

Free Financial Spreadsheet Tools from Google Docs

One of my computing goals is to use “cloud computing” as much as possible. This means no application software clogging up my laptop or desktop. Instead, I prefer to use web-based applications. Google is a leader in that trend.

Google Docs is a set of office-type applications, including a word processor compatible with Microsoft Word and a spreadsheet program compatible with Excel. Google has gone beyond providing the browser-based software for free. It has also made available 33 different personal finance templates that you can use with its Google Docs applications.

The templates are organized into three different sections. (See below.)

Here is a list of all of the personal finance templates.

Some of my favorites are the Family Budget Planner, the Personal Budget Tracker, and the Savings Calculator.

Because these are all web-based applications, you can use and access your free money management tools from any computer using your private Google Account. No need to carry around data or software.

If you want to use the templates off-line, Google Docs does have an offline usage feature (you will have to load some code onto your computer) or you can try to convert the templates into another format.

Give Google Docs and its personal finance templates a try. You might like them. Being free helps. More money management tools will likely be added in the near future.

Photo credit: Bright tal

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