Financial Calculators: What You Don’t See

by | Jul 9, 2021 | Blog, Podcasts

In this week’s podcast, Tom and Casey pull back the curtain and examine how financial calculators arrive at their results.

Financial calculators, also known as retirement calculators, take a snapshot of where you are now and project it out into the future. Not taking into account any changes or course corrections along the way.

Life doesn’t move in straight lines. That’s why we believe financial planning is an ongoing process, not a one time event.

Show Notes

The Hidden Assumptions of Financial Calculators – MorningStar

You Can’t Invest Without Trading. You Can Trade Without Investing – Wall Street Journal

Financial Calculators: What You Don’t See – Transcript

**Click here for a downloadable PDF version of this transcript**

Casey Mullooly: Welcome back to the Mullooly Asset podcast. This is episode 363. This is your host Casey Mullooly. I’m joined here by Tom Mullooly. And as per usual, we’re going to cover some headlines and topics that have been getting discussed recently in the financial media and these are topics that we find relevant and we hope you get some good takeaways from.

So, a recent article that we caught our eye in Morningstar was talking about the hidden assumptions of financial calculators. So, we see these financial calculators all over the web now. They’re pretty much in most of the custodians have them right there in people’s accounts for them.

We know Fidelity has one, Vanguard has one. I’m sure Schwab has a version of it as well. And what these retirement calculators do is someone has an account, it takes their account value. It makes some assumptions like returns and time horizon and it spits out a percentage of… Sometimes it’s not even a percentage, it’s just a color or a scale that tells you whether you’re “okay” or not.

Tom Mullooly: On track.

Casey Mullooly: On track.

Tom Mullooly: Right.

Casey Mullooly: Right. So, we wanted to break down some of these assumptions and dive into this a little bit because it’s certainly something that we help folks figure out and a lot of folks come to us and say, “Look, this thing’s telling me I’m okay. Is that true?”

Tom Mullooly: I’m happy that people come to us and ask us if it’s true, because I think there’s a larger percentage of people out there who just take it as the answer.

Casey Mullooly: Yeah.

Tom Mullooly: And so, “Well, you know what? The green light of fidelity says that I can…” Those stupid commercials have that green path on the floor. Like, “Oh, we’re on easy street, let’s go.”

Casey Mullooly: Right.

Tom Mullooly: The thing with these financial calculators is they’re calculators. A lot of people who know me well say, “Wow, you’re really good at math.” And I’m like, “No, I just played with a calculator instead of video games when I was growing up. I just started doing a lot of math in my head and I got faster and faster on calculators.”

But you need to understand that it’s a tool. It’s a calculator. There are things built into the calculator that some of them can be changed. Some of these calculators are hardwired.

Casey Mullooly: Yeah.

Tom Mullooly: Some of these calculators have a 2% inflation rate, that’s hardwired. You can’t change that.

Casey Mullooly: Straight line 2%, meaning 2% every year for the next 30 years or whatever.

Tom Mullooly: Yeah, which is just not rational.

Casey Mullooly: Right. So, the calculators use average numbers, which we’ve talked about before on the podcast, but the danger of using average numbers as we’ve explained is that you can get a 10% annualized return, but it’s going to be 30% in the first year, nothing in the next two years.

And then you got your annualized 10% return. But the way that that impacts a retirement plan is when these calculators bake it in in a straight line, 8% a year, it’s like, “Okay, well, as long as I take out four, I’m still-“

Tom Mullooly: Making eight and taking out four. Yeah.

Casey Mullooly: “… I’m not dipping into my principal at all.”

Tom Mullooly: Yeah.

Casey Mullooly: But-

Tom Mullooly: It never works that way.

Casey Mullooly: … it usually doesn’t work out that way.

Tom Mullooly: There was a podcast that Brendan and I did where at the time we had recorded the podcast, like the rolling 10-year return for the S&P 500 was 6%. And there was not a single year or quarter where it was exactly 6%. Like it never works out that way.

Casey Mullooly: It’s the same with inflation.

Tom Mullooly: Yeah.

Casey Mullooly: Now, people don’t see these assumptions. They can’t tweak these assumptions. They’re kind of just baked in and the custodians provide the assumptions for them, usually based on historical returns or historical averages, which are usually right, but it’s in a straight line and life doesn’t move in straight lines.

Tom Mullooly: Yeah. It’s important that people who tinker with these financial calculators understand how they work before you get to the green bar that says success. So, what’s happening under the hood, they want to see like all different possible outcomes where you have a couple of bad years upfront in the market while you’re retired, a couple of bad years in the middle of your retirement, a couple of bad years towards the end of your retirement.

And what they want to do is they basically want to give you a score. What they’ll do is they’ll spit out either a color or a letter like A+, or sometimes they’ll give you a percentage like you’re 95% there. How do they know that? So, let’s talk about that.

Casey Mullooly: The article has a pretty interesting table that breaks down the success rate. So, if you’re on 100% success rate, the withdrawal rate as a… So the withdrawal rate is the percentage of your assets that you’re taking out-

Tom Mullooly: To live on-

Casey Mullooly: … to live on each year. So with the 100% success rate, the withdrawal rate needed to accomplish that in this situation is 2.4%.

Tom Mullooly: So, let’s hit the pause button and talk about this. Before you launch these calculators, they’re going to ask you, “What’s your starting balance? What’s your age? When do you plan on retiring? When do you start to take money out and how much do you think you’re going to need to take out on an annual basis, just guess?”

And so, what they’ll do is, if you have a need of say, “I need to take $10,000. I’m getting a pension, I’m getting social security, but I’m still going to be about 10 or 12 grand short. So, $1,000 a month while I’m in retirement.”

If you have a $100,000 retirement fund, you’re taking out 10% or maybe 12% of your account value over the first year. If you have a million dollars and you need to take out $10,000 or $12,000, well, you’re only taking out 1% or 1.2% of that number.

Tom Mullooly: What Casey was just saying was that if you go through these financial calculators and you want to hit 100% success rate, you have to take out 2.4% or less to be able to weather all of the up, down, sideways markets that you’re going to see over the next 30 years on average.

Casey Mullooly: Right. One of the issues that I have is how do you nail down what a good success rate is or what success rate people want. Obviously, everyone wants 100% success rate, but sometimes that’s just not realistic.

Tom Mullooly: A lot of people don’t have the money.

Casey Mullooly: Right.

Tom Mullooly: They don’t have enough money or they have too much of a need-

Casey Mullooly: Yeah.

Tom Mullooly: … and they just have to take out more. That’s the way it is. A lot of people don’t have pensions.

Casey Mullooly: Yeah. So, as the success rate falls, if you’re on a 50% success rate for instance, your withdrawal rate needs to be 5.3% or less.

Tom Mullooly: Right. So, some websites, I think they mentioned Schwab in there, lower their success rate to something like 75%.

Casey Mullooly: 75% to 90%.

Tom Mullooly: Which means that you’re taking out 4%, 4.5%f percent, we still think that’s a little rich. Let’s face it. It’s going to really suck if you run out of money at 71 or 72. We actually had to show that to a client a couple of weeks ago. That’s not a fun conversation because either that client needs to work more, save more or readjust how they’re going to be spending money in retirement.

Casey Mullooly: Yeah.

Tom Mullooly: Or both. So, these things are tools. They’re not the answer. This isn’t the Wizard of Oz.

Casey Mullooly: Yeah.

Tom Mullooly: You do have to pull back the curtain and see the guy who’s standing behind it and see what’s going on with this. They do make a lot of assumptions about what you are putting in, what the withdrawal rate is going to be, like how much money you need to take out. But they’re making some assumptions about what stocks are going to return.

Casey Mullooly: Yeah.

Tom Mullooly: What inflation is going to be, what are interest rates going to be like?

Casey Mullooly: The outputs are only as good as the inputs.

Tom Mullooly: Yeah. Garbage in, garbage out.

Casey Mullooly: Right. And so you really got to question your inputs and you really got a question what’s happening under the surface.

Tom Mullooly:
But Casey, some of the problems with some of these tools is that you can’t go in and tinker with, “Hey, I think inflation is going to be higher in the future.”

Casey Mullooly: Right.

Tom Mullooly: You can’t even change that on some of these calculators.

Casey Mullooly: Right.

Tom Mullooly: And unfortunately, people are taking what the computer is spitting out as gospel.

Casey Mullooly: Yeah.

Tom Mullooly: We spend a lot of time talking about what cash flow might need to look like in retirement for our clients and what happens the first year or two or three that people are full-time retired. They tend to do a lot of traveling.

Casey Mullooly: Mm-hmm (affirmative).

Tom Mullooly: And so, it’s very possible that your expenses could be ultra high for the first couple of years while you’re retired and then they’re going to settle down. I think you’re going to spend a lot less when you’re 81, versus 71.

The numbers are going to change. So think back to the process that you went through when you were using a calculator and you said, “Yeah, I’m going to need an extra $10,000 a year from my retirement plan.” That could be totally wrong for a few years and then totally right.

Casey Mullooly: You got to question these assumptions. You got to take a second look at these things just because the green lights are on, or you’re walking down the path, so to speak, doesn’t necessarily mean that that’s going to be the case in the future.

Tom Mullooly: One of the things that we stress to our clients is that planning is an ongoing process. It never ends.

Casey Mullooly: Right.

Tom Mullooly: So we’re consistently reviewing the numbers with our clients all the time. Do we want to spend a minute and just talk quickly about something that we mentioned in episode 362 about trading versus investing?

Casey Mullooly: Yeah. A recent article in The Wall Street Journal from Jason Zweig who is one of the best writers in the financial industry. He’s been doing it forever and he keeps finding ways to say new things about the same stuff. But the headline was, You Can’t Invest Without Trading.

You Can Trade Without Investing. So, the main point of the article was that financial publications such as The Wall Street Journal, he calls out his own people here that they misuse the word investor when they’re really talking about speculators. So I just want to read a quick passage from the article.

“An investor relies on internal sources of return, earnings, income growth in the value of assets, a speculator counts on external sources of return, primarily whether somebody else will pay more regardless of fundamental value.” So, the difference is speculators invest because they just see the price of whatever going up.

Tom Mullooly: The greater fool theory. Like there’s always going to be a greater fool who will buy this from me, or I can sell it to.

Casey Mullooly: Right. But investors rely on what the companies are actually doing. Their internal cash flow reports, their balance sheets, what the products that the companies are making and investors invest because of that, not because they just see a big green arrow next to the company’s name.

Tom Mullooly: It’s bothered me for my entire career that you turn on TV and you see these chuckleheads on there talking about, investors bid up the price of, fill in the blank today, or investors bid down the price of ABC today. No, they didn’t because that wasn’t investors.

Casey Mullooly: Yeah.

Tom Mullooly: Those were traders and speculators. So let’s get the jargon right.

Casey Mullooly: Right. Let’s take the meme stocks, for example, which mentions in the article. So, those-

Tom Mullooly: GameStop.

Casey Mullooly: … GameStop, AMC.

Tom Mullooly: You can even throw in Tesla in there.

Casey Mullooly: You could throw in Tesla. So would you classify those as investors or speculators?

Tom Mullooly: GameStop was essentially left for dead a couple of years ago, they used to be a chain of video stores. Now they’re trying to change the business, but-

Casey Mullooly: There were video game stores.

Tom Mullooly: They were. And now they’re trying to change a little bit of what they’re doing, but they still have stores.

Casey Mullooly: Right.

Tom Mullooly: They still have fundamentals and the fundamentals don’t match up to the price of the stock right now. This thing is trading in the stratosphere.

Casey Mullooly: It just doesn’t match reality. It feels so wrong.

Tom Mullooly:
Yeah.

Casey Mullooly:
But.

Tom Mullooly:
But it goes up almost every day.

Casey Mullooly:
Right. So, what was the answer to your… Sorry, I kind of cut you off. Are they investors or speculators?

Tom Mullooly: They have to be speculators.

Casey Mullooly: Right.

Tom Mullooly: They have to be.

Casey Mullooly: That’s the whole idea behind it, is these people… I don’t want to speak for them, but just what I perceive their motives to be is like you said, they’re going to pump up the price of the stock and then sell it to someone else and get out. And then they’re going to be left holding the bag.

Tom Mullooly: Right.

Casey Mullooly: I think Zweig makes a really good point that you have to make trades to be considered an investor. But just because you make trades, doesn’t make you an investor.

Tom Mullooly: I think that investors in general will make less trades than speculators, because a speculator doesn’t need a reason to trade. A speculator doesn’t need an event to trade.

They can just say, “Well, I’m up five points in this thing. I’m going to flip it.” In fact, years ago when I was a broker, I used to have a doctor client who would say… We had 5,000 shares of his stock and he would say, “If you make a point, you flip it.” And that was his instructions all the time. You make a point, you flip it.

Casey Mullooly: Yeah.

Tom Mullooly: And then he would hang up.

Casey Mullooly: Yeah.

Tom Mullooly: So, those people are just speculating. They’re trying to just make a buck here and there where they can. And they’re going to have days where they lose and they’re going to have days where they win big.

And they hope that the winners outstrip the losers, but an investor is saying, “Hey, I want to buy the house next to yours.” That’s the way I always feel an investor ought to look at things. Like, “I’m going to sink some roots into this thing. We’re going to be here for a while. You better get used to see me around.”

Casey Mullooly: Are the schools and neighborhoods good?

Tom Mullooly: Yeah. We’re going to work on that front lawn.

Casey Mullooly:
Right. Exactly.

Tom Mullooly: So.

Casey Mullooly: Zweig attributes speculators success to luck rather than doing your homework and spending time on these things.

So, luck could be confused as skill, which leads to overconfidence, which leads to people taking unnecessary amounts of risks and speculating even more and up and up and up and then it spirals out of control because they believe themselves to be a successful investor when really all they were doing was just speculating based on nothing.

Tom Mullooly:
If you take enough swings with the bat, you’re going to get some hits. And that’s always been the rule. I think the thing about investing is that a skill that comes with identifying a good investment or a bad investment, skill like that is transferrable.

Meaning you can look at companies in one industry and transfer that same skill to a different industry, and you could also transfer it to mutual funds and to bonds and say, “Okay, I can recognize that there’s value here.” But luck is not transferable. Luck just happens.

Casey Mullooly: Mm-hmm (affirmative).

Tom Mullooly:
And so I got lucky trading Tesla, and then I got lucky trading, fill in the blank.

Casey Mullooly: Yeah.

Tom Mullooly: I got lucky doing this, but the problem is a lot of traders/speculators will not say it’s luck.

Casey Mullooly: Yeah.

Tom Mullooly: They’ll say it’s skill.

Casey Mullooly: Right.

Tom Mullooly: We’ve got an obligation to the folks that we work with that we’re not going to be speculators. We don’t deny the fact that speculators can make lots of money.

Casey Mullooly: Yeah.

Tom Mullooly: They can do really, really well.

Casey Mullooly: Definitely.

Tom Mullooly:
And we’ve met a few people who we’ve told them, “We’re not right for you because you’ve demonstrated the fact that you can trade actively and do well. Good for you. That’s great. We’re not going to be doing that.”

Casey Mullooly:
Right. Like we say in our slogan.

Tom Mullooly:
It’s not luck. It’s planning. We mean that.

Casey Mullooly:
And with that, we’re going to wrap up episode 363. There’s a lot of good stuff in there. We hope you got some good takeaways and we will see you on 364.

Casey Mullooly: Tom Mullooly is an investment advisor representative with Mullooly Asset Management. All opinions expressed by Tom and his podcast guests are solely their own opinions and do not necessarily reflect the opinions of Mullooly Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Mullooly Asset Management may maintain positions and securities discussed in this podcast.

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