John Rekenthaler, CFA, Vice President of Research for Morningstar, muses on the difficulties in deciphering investment planning with the help of an example from the international press, in which the reporter gets in a twist over a US pension plan.
A few days back, The Wall Street Journal ran an article on getting your 401(k) back on track. Included in the piece were several calculations run from popular online investment planning services (one of which was from Morningstar).
This item struck my attention: "Let's assume you're 50 years old with a $500,000 portfolio, contributing $1,000 a month to your 401(k) and planning to retire at 65 ... If you were 70% invested in stocks, the [name withheld to protect the innocent] model predicts that at 65 you could have annual income from about $89,000 if the market performs poorly to $476,000 if the market performs very well." The article goes onto say that the median income under the projection is about $190,000.
I stopped right there. Say what?
Let's get out the back of the envelope. Take a $500,000 portfolio, over 15 years, assume a generous return of 5% annually (generous because I happen to know that the model in question makes its projections in real, after-inflation terms, and 5% real after expenses is pretty darned good), that's about $1,000,000. The $1,000 per month donation is less significant, that might account to another $250,000 by age 65. So $1.25 million total. Plus some Social Security.
And that's going to give a median income of $190,000? Even if Social Security is assumed to be a healthy $40,000, that's $150k per year coming out of a $1.25 million portfolio--12%. No, that ain't happening, not unless our 65 year old doesn't mind perhaps running out of money as early as his or her late 70s. (More realistically, a fixed annuity rate for a 65 year old single male is about 6.5%.) As for the market heroics required to arrive at an annual income of $476,000, well my envelope is now starting to emit black smoke. The returns would have to be at least 20% real over the 15-year period. At least.
So, I don't know what was going on, except that the actual model is certainly not so wacky. Rather, the reporter must have misentered or misunderstood some of the data. Perhaps the model is reading the inital asset as being much larger than it is, or that the user has entered a termination date of age 80, or something. But the point is, it's a big error, yet neither the reporter nor her editor caught it. And this is The WSJ. If the Journal can't grasp the numbers, who will?
My point being, investment planning is nonintuitive. There's no way to get the numbers to make sense--to all but the most experienced user, it's gibberish in, gibberish out. And people can't internalize gibberish. They can't take it to heart, and truly believe it. So when they receive the projections of what they must save, and how much, and how much they will have, well it just doesn't catch hold of them. It's just numbers.
Finally, it sure would be nice if those figures were true, eh? With a half-million nest egg at age 50, just work another 15 years with 401(k) contributions, but no additional savings, and expect about $200k annually at the time of retirement. Sign me up for that deal. Please.
