When Napkin Math Falls Short
Using a compound interest calculator and the 4% Rule (sometimes used to create “napkin math”) can give you a rough estimate of whether you have or are saving enough money to eventually retire. But in many distinct and specific ways, napkin math falls short and might not provide an accurate enough estimate of whether your retirement will be secure.
Here are the most common factors that “napkin math” often fails to account for, and which a full-fledged Financial Plan includes and incorporates:
Social Security timing –
- Lots of napkin math doesn’t factor in your social security benefits (or even Medicare).
- Retiring earlier than 62-67 means your benefit estimate is likely too high.
- Napkin Math does not help you determine whether it is optimal to start social security at 62, 67, 70 or some age in-between.
Private Health Insurance – especially if there is a gap between your last working years and 65 (the year you will start Medicare), you will have to factor-in what is likely a much higher cost for private health insurance during the “working-to-age-65” period or gap.
Taxes – Ensuring that the payment of taxes is factored in and calculated correctly for working years versus non-working years.
- Factoring in taxes from IRA distributions, Roth conversions, Social Security benefits, Required Minimum Distributions (RMDs), taxable interest and dividends, and tax loss harvesting/capital gains from taxable brokerage accounts can be complicated.
- The account type that you withdraw from during retirement will greatly impact how much and when you pay taxes. Traditional accounts, Roth accounts, and taxable accounts all have greatly different tax treatments.
Roth Conversions – performing Roth conversions, when appropriate, can shift future (higher-rate) taxes to earlier (lower-rate) taxes prior to starting Social Security or distributing required minimum distributions (RMDs). These strategically timed Roth conversions can often make a big difference in the longevity of retirement savings and your lifetime amount of taxes paid.
Your Withdrawal strategy – Which types of accounts you withdraw your “retirement paycheck” from majorly impacts your taxes. This impact on taxes is rarely included in ‘napkin math.’ Determining which accounts you should be withdrawing from first, or whether it would be optimal to withdraw from multiple types of accounts every year, is an important aspect of your comprehensive financial plan.
Non-linear expenses and/or withdrawals – Inevitable house maintenance like replacing the roof, water heater, HVAC, AC unit, and miscellaneous repairs must be factored into a retirement plan. Averaging these expenses into your yearly expenses isn’t accurate-to-life. Instead, factoring in “lump expenses” of $5,000 or $30,000 (or whatever they are) every 5-15 years can be much more accurate.
- You may have heard of “Go-Go, Slow-Go, and No-Go” years – an apt description to account for the fact that everyone’s “Lifespan” is not the same thing as their “Health span.” You will likely spend more on travel, leisure and personal spending in your first 10 years of retirement. You will likely then spend a little bit less on those types of expenses in the next 10 years after that. And then at some point you probably won’t be healthy enough to be regularly travelling.
- Another variation of the above is the “spending smile.” You usually spend more on travel and activities right after you retire – then your spending dips in your 70s, and then it increases again in your 80s or 90s as you have increased health spending and/or long-term care needs. Napkin math almost never accounts for the significant differences in expenses during these different phases of life.
Sequence of Return Risks – using a compound interest calculator showing 8% market returns every year for 30 years is almost certain to be inaccurate. The returns your investments will receive and the sequence in which those returns occur (i.e. the market going up, then down, every other year versus going up for 5 straight years, then down for the next 5 straight years) makes a huge impact on how long your retirement capital will last. In reality, returns will look more like up 13% one year, down 2% the next year, up 5% the year after that, then up 15%…etc.
Napkin math does not account for these non-linear returns – but it something that Monte Carlo simulations can help factor into a retirement plan.
Long-Term Care – most people don’t include in their Napkin Math the exorbitant costs involved in needing long-term care for themselves or their partner at the end of their life.
- Having LTC insurance or significant assets to cover LTC costs is important so you don’t run out of money in your most vulnerable years or financially burden your children or family during the last years of your lives.
Inflation – most compound interest or compound growth calculators don’t include inflation in their calculations.
- Ending with $5 million in 30 years might seem great, until you realize that thanks to inflation, the buying power of that $5 million is only the equivalent to ~$2 million (with 3% inflation). Making sure you understand how inflation will decrease the buying power of your future dollars, and then factoring that into your financial plan can be critically important.
The above are only a handful of the most obvious and impactful reasons why “napkin math” (which can be good enough for general planning and discussion purposes) falls short when it comes to making critically important decisions surrounding retirement.
Please contact us at: Contact Arrivity or 206.217.2583 or info@arrivity.com if we can assist you or someone you know with financial planning.
Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.