Planning for retirement isn't always just basic math. Too many people plan with the aid of a retirement calculator, without understanding the inputs that go into these ultra-important calculations.
Sweat the Details
Planning for retirement requires that investors make assumptions about the future, with one of the most important being the expected return of their investment portfolio.
However, these assumptions create problems that are two-fold. First, average investment returns hardly mean always, and even positive averages can create losses. Second, average yields usually drop as retirement investors decrease their exposure to risk as their retirement date comes closer.
Average is not Always
One of the inputs into a proper retirement plan is an expected yield from your investments, typically described as an “average return.” One important thing to remember about averages, whether buying into a new mutual fund or planning for retirement, is that the average return is not the absolute return.
For instance, a mutual fund with a 5 year average return of 20% could have yielded 0% for four years and a 100% return in the fifth year. Or, in an extreme case, the fund could have lost 50% one year, earned 0% for three years, and then earned 150% the last year. The total return would have been -25%, though the average five year return would have been 20%.
Plan for Reductions in Risk
Most automated retirement calculators and even some financial planners are a little too optimistic when it comes to planning for retirement. Often, they'll assume a fixed 8-9% annual return from the day you open an IRA to the day you set your foot on the beach to begin a 30 year retirement.
The problem here is that you're unlikely to generate 8-9% returns in the final stretch to retirement, mostly because you'll want some extra security. If there is anything to be learned from the financial crisis of 2008-2009, unexpected events can happen, and it is best to remove as much risk as possible in the final years to retirement to avoid any catastrophic losses that could extend your retirement countdown.