[Ntrails]

Following on from leaving the thread of the topic…

I've yet to see a single early retirement blog deal with the issues of investment risk, inflation risk and longevity risk properly. It's starting to drive me a tad potty. I will literally buy you a [starbucks] cookie and mail it to an address of your choosing if you promise to start using "Expected Annualised Real Return" instead of "average interest".

To be specific about the problem, a 4% annual interest over 4 years could represent: 2%,2%,4%,8%. Those will result in something different to a flat 4% pa. If you are going to have a withdrawal you need to work out what you do in the 2% years, because otherwise you have less money earning interest than expected and your gap starts to widen. Now what if the fed prints a crapload of money to lessen the national debt load, and you are suddenly facing $10 coffees?

Anything other than the risk free rate needs to be treated properly, as a risky return, or we are going to see in 40 years a lot of people who thought they'd saved enough for early retirement, but it turns out they had not.

Disclaimer: I am an actuarial student working in investment at a pensions consultancy. My living revolves around trying to quantify these risks.

[kablamo]

Thats a great point. I do mention it in my blog post on withdrawal rates! (http://blog.networthify.com/withdrawal-rates/)

Its worth nothing that you could end up with an ever widening gap, but you could also end up with an ever growing surplus if your early years get > 4% return.

I don't think any calculators really deal with this other than http://www.firecalc.com/ (which has a terrible ui -- look for the big red 'Start Here' text and then click the 'Submit' button). Building a user friendly firecalc clone has been on my todo list for while. I'm not sure where they got their data.

With regards to my other calculators on Networthify, I'm not sure how to create a usable ui that reflects this reality.

Also there are at least 2 other big unknowns -- taxes and inflation. So when I'm calculating how much money future-you will have I'm not too worried about ROI. I agree that people need to understand these calculators are just educated guesses. Still -- you do the best you can with the information available. Its better than closing your eyes and not even examining the possibilities. At least you can calculate some worst case and best case scenarios.

-- UPDATE

Oh hey, do you mean there is some sort of formula for expected annualized return?

[Ntrails]

Of course there is upside to risk, but that doesn't really help me plan for the future. The upside is nice holidays; the downside is penury and food banks. It really is that bad. I would never talk to someone about their 99th percentile asset value, but I might well show them their 1st percentile and ask them a simple "what if"

At it's most basic savings for retirement should be considering things like "what does a 40% drop in the market mean for me?" "What does uncontrolled inflation mean for me?" "what happens if I live to over 100?"

In general, I obviously believe that knowingly flawed models are better than nothing. If you want to demonstrate some of what's at risk, do a single "1 in 200" scenario. So all of the above in one example. Half way into the projection period the portfolio drops by 40%, inflation doubles and you increase the projection period by 20% (pulling a deterministic scenario firmly from thin air). You can fudge the maths a little and simply output 2 sets of figures:

Expected present value || Risky Scenario present value

The risky scenario parameters can be hidden away with the other more advanced things, and you've got yourself a nice output demonstrating what could conceivably happen. There are other ways, but it depends what and how much you want to show.

More than anything though, I just want to see these calculations properly phrased as estimates. Returns defined clearly as real (or nominal, and model inflation). And a mention given to the cost of living longer. For a cup of coffee, no one cares - not even I. We are talking about 80 year olds having to find work to help account for a depleted nest egg. It's really serious stuff.

RE: Edit Annualised return is simply (1.021.021.06*1.04)^(1/4). You are calculating these things based on an expected return on assets, it is important to be clear that it is not an arithmetic average that you are using but a geometric one. I don’t know if you are modelling the withdrawal cashflows (there is no need with a constant rate of interest) which is really where this stuff starts to hit home.

[kablamo]

I'd love to chat with you about this stuff on email if you are interested. My email address is in my HN profile. Thanks for the comments!