Research, Technology,
The Trouble with Calculators
Anybody who has fiddled with retirement planning calculators knows they aren't flawless crystal balls. Each has unique idiosyncrasies, and their conclusions are only as smart as the people using them. “Garbage In, Garbage Out,” as the geeks say.
So no surprise that two researchers, after deconstructing a dozen popular calculators designed for “managing risks and resources in retirement,” accused them all of biases and blind spots that limit their usefulness, especially for the amateur investor.
In the 118-page study, “Retirement Planning Software and Post-Retirement Risks,” prepared for the Society of Actuaries and The Actuarial Foundation and published last month, Pension Policy Center economist John A. Turner and attorney Hazel A. Witte found that, to some degree, all the calculators:
- Produce inconsistent results from similar inputs.
- Overstate rates of return, often ignoring fees and other frictions.
- Favor stocks, skate past Social Security benefits and ignore annuities.
- Assume an unrealistic level of financial literacy among users.
- Overstate the percentage of their pre-retirement income that retirees will need.
Ouch! To be fair, this study attacked something of a straw man. The retirement income planning process entails so many variables and unknowns, is so individualized and has so many unresolved theoretical issues, that no calculator—free or professional-grade—could be perfect. It should also be assumed that most free calculators are intended mainly to generate sales leads or to make websites stickier.
Still, retirement planning calculators in general cry out for a makeover, and this aggressive study, which builds on a similar 2003 study, is an overdue wake-up call. It describes easy ways to improve calculators. It also shows how to improve the retirement income planning process itself. [An 11-page Highlights Report is also available.]
‘You need to save more’
Turner and Witte looked at five free online calculators for consumers, one consumer program that charges a fee, and six programs designed for financial advisors. All are commonly used and were chosen non-randomly.
The advisor programs, not surprisingly, tended to be more detailed and better suited for the complex needs of high net worth investors. The consumer programs were simpler, but generally failed to reflect recent findings that many Americans don't understand basic concepts like compound interest.
“One of the newer developments in economics is behavioral economics,” said Turner, a former government economist who worked for AARP before starting the non-profit Pension Policy Center in Washington, D.C. two years ago. “It's been a surprise to most economists how little most Americans know about investments and financial markets. A key problem with the calculators is that they haven't taken that insight into account.
“The calculators assume that the typical user knows a lot more than he does, and therefore they allow users to make errors studies predict they will make. They don't offer the appropriate feedback when people make errors. That's a fundamental but easily fixable problem.”
Overall, calculators emphasized offensive strategies (i.e., investing and accumulation) over defensive strategies (i.e., risk assessment and mitigation). That is, they reflected the still-prevalent assumption that to ensure a secure retirement you must amass a modest fortune of $1 million or more.
“Typically, calculators do a calculation and then tell you that you need to save more,” Turner said. “But they should also say, ‘You may need to retire later or buy an annuity or spend less in retirement.’” Asked if this might reflect the business goals of investment companies, he said, “There is an element of that going on.”
That bias tends to encourage bullish growth assumptions. “One of the areas we looked at was the appropriate rate of return to use. For instance, if you input an expected return of 21%, the calculator will say, ‘that's too high.’ But you can input up to 20% percent and get no feedback from the calculator. It would be better if they provided a cue that told people to underestimate > their returns.
“When the market was doing well, people in general or on average somewhat overestimated the rate of return they could expect to receive. It wasn't unusual for them to say think that they'd receive 10% going forward. Even after the last few years, I still think people have a tendency to overestimate their returns,” Turner told RIJ. [The calculator on T.Rowe Price's site assumed an after-expenses average return of 8.8% for stocks, 5.75% for bonds, and 4.1% for short-term bonds.]
The more-is-better mantra also expressed itself in the calculators' assumption that retirees need 70% of their pre-retirement income. Turner agrees with Larry Kotlikoff, the creator of ESPlanner retirement software package, who has argued that retirees can live on far less.
“The target replacement rates do seem to be very high, and that seems to be a pervasive problem, Economists assume that people want the same standard of living when they're in retirement as when they are working,” Turner said.
“But let's say you had two kids while you were working, and that your kids were using up a lot of income. That's a simple point but none of the calculators take the number of children you have into account. That's not a difficult problem. It just adds another line to the program. But that one change would be a significant improvement.”
Annuities and Social Security get short shrift
Reflecting the pro-investment tendency, these retirement-oriented calculators don't even hint at the possibility of using annuities. Nor they do help people understand how to integrate the annuity that everyone has—Social Security—into their income planning.
“Hardly anybody, even the insurance companies, tends to push annuities,” Turner said. “None of the mutual fund companies have anything to say about annuities. They don't sell them and their assumption is that you will stay with their mutual funds. The only questions how much you have to save or how much you can consume out of what you have saved.
“We know that most people don't annuitize, and it's not the fault of mutual fund companies that people don't annuitize, but it's still a fundamental problem with the programs,” he added. [The MetLife calculator has a link to an income annuities page and to an illustration of Social Security claiming strategies. In a footnote, the T. Rowe Price calculator has a direct link to the Social Security Administration site.]
While more detail is often good for an advisor-oriented calculator, the doctrine of less-is-more may serve consumer-oriented calculators better, Turner said. People love horoscope books, which provide reams of purported insight based on no input other than the reader's birthday. Why not devise a retirement income planning calculator that requires minimal inputs?
“It would be interesting to ask, 'What would the ideal calculator be?' assuming that you only asked 10 questions, and that you provided have cues and suggestions for answering them. Questions like, 'How many children do you have? What is your age, your income, your gender, and when do you want to retire?'” Turner speculated. [One of Fidelity's tools, "Find retirement income products," is a decision tree that leads users to products based on their answers to just four questions.]
Call it the paradox of consumer questionnaires. “The problem with online calculators is that if they take more than five minutes they won't be used, but if they take five minutes or less they won't have much value,” Turner said. “There is that tradeoff. But even in the ones with modest goals, there's room for improvement.”
© 2010 RIJ Publishing. All rights reserved.
Industry Views,
Roth IRA Conversion Promotions Are All The Rage Online
On January 1, 2010, all of the advantages offered by Roth IRAs — tax-deferred growth, tax-free distributions and no required minimum distributions — became available to a new demographic of investors thanks to a provision in TIPRA (Tax Increase Prevention & Reconciliation Act of 2005).
Previously, individuals who had modified gross adjusted incomes above $100,000 a year or were married and filed separately were unable to convert their traditional, SEP or SIMPLE IRAs to Roth IRAs. Signed into law in 2006, the TIPRA provision eliminates these restrictions, extending Roth IRA eligibility to the higher earning investors that are coveted by top firms.
In anticipation of the impending Roth IRA conversion opportunity and the subsequent influx of higher net worth investors, more than half of the firms we cover have introduced focused Roth IRA sales campaigns and resources online over the last six months. Firms have aggressively targeted both prospective investors and financial professionals in an attempt to establish footing with these key audiences.
John Hancock and Pacific Life have been the most active firms, rolling out impressive online sales campaigns equipped with engaging education and sales resources. John Hancock's 2010 Roth Opportunity campaign is publicly available and targets prospective investors and clients. Pacific Life's Roth IRAS: Take a New Look campaign is featured exclusively on advisor websites and focuses on advisor sales support.
Homepage promotions, a page dedicated to Roth IRA education, an educational series of videos and four new calculators make up the comprehensive John Hancock Roth IRA Opportunity campaign. The homepage promotional images, which have been running since September, link to the informative Roth IRA Center page. A comparison table highlighting differences between Traditional and Roth IRAs is presented along with a list of nine investor suitability considerations.
John Hancock Roth IRA Center
The aforementioned Roth IRA-focused videos and calculators are also accessible from the Roth IRA Center. The three part video series looks at key strengths, investor suitability considerations and potential retirement and estate planning benefits related to the Roth IRA Conversion. The four calculators help users perform detailed comparisons between Roth and Traditional IRAs, breakeven analysis and hypothetical legacy planning.
The Pacific Life Roth IRA Conversions: Take A New Look campaign is advisor-focused and offers a diverse selection of engaging client and advisor education resources and sales materials. The firm has been promoting the campaign on the homepage for nearly three months using a variety of colorful images.
Pacific Life Roth IRA Conversions: Take A New Look Homepage Promotion
Homepage promotions all link to a campaign-exclusive sales resources page that has been frequently updated over the past three months. Advisor education brochures are made available along with a variety of sales materials for use with clients including informational brochures, pamphlets, prospecting letters and marketing flyers.
Pacific Life Roth IRA Conversions: Take A New Look Sales Resources Page
It is no secret that the past 15 months have been unkind to the financial services industry. The Roth IRA conversion represents an excellent opportunity for firms to add new clients and bolster their businesses in the new year.
© 2010 Corporate Insight, Inc. All rights reserved.
Industry Views are special reports that are sponsored and independent from RIJ's editorial content.