In last month’s post I introduced you to FIREcalc (http://www.firecalc.com/), one of the best free retirement calculators on the internet. FIREcalc is normally used to estimate one particular instance of shortfall risk: the risk of outliving one’s money in retirement. But last month, we worked through an example that showed how FIREcalc can be “tricked” into estimating the shortfall risk for any financial savings goal you may have. In the example we worked through, we estimated the shortfall risk for a $50,000 savings goal, to be reached in 10 years, by saving $3,000 per year. Based on the results from FIREcalc, we found that there was a 5.9 percent chance of coming up short of the $50,000 goal.
So, using FIREcalc, we now have a way to estimate shortfall risk not just for retirement, but for any financial goal we may have. But simply being able to estimate this risk isn’t enough. We also have to be able to decide how much risk we’re willing to accept. Going back to last month’s example, is a 5.9 percent level of risk—basically a 6 in 100 chance of coming up short of our $50,000 goal—acceptable? Or, do we need to tweak our savings plan and/or our mix of investments to change our odds of failure?
The short answer is, it all depends on your personal circumstances—and your relationship to your financial goals. What is an acceptable level of risk to you for your particular goals will differ from what is acceptable to me, for my goals.
But that obvious point said, there is a key question you can ask yourself that will help you to hone in on your personal shortfall risk “comfort zone”: how important to you is the specific goal you are saving for? For example, you might consider saving for your kid’s college education to be an extremely important goal—and therefore a goal for which you are willing to accept little or no shortfall risk. Returning to last month’s example, you might consider a 6 in 100 chance of coming up short of the money you need to send your child to college an unacceptably high risk. On the other hand, you might be willing to accept a much larger degree of risk for a goal that you consider desirable, but not a necessity. Examples of the latter “nice, but not necessary” goals might, for example, include a dream vacation or a boat. To achieve these kinds of goals, a shortfall risk of 6 in 100 might actually be too small, especially if the amount of money you must save to reach the goals would entail a significant sacrifice.
It’s important to come up with an actual shortfall risk estimate before you try to decide on an appropriate risk level, as it is much easier to decide whether a specific number is acceptable than to try to come up with an acceptable number or range of numbers in a vacuum. With an initial estimate of your shortfall risk in hand, all you need do is answer, yes or no, whether that number is acceptable to you. In other words, having a specific shortfall risk estimate in front of you helps to turn what would otherwise be an abstract decision-making process into a much more concrete process.
So, the first step in deciding on whether or not you need to modify your savings/investment plan is to estimate the plan’s shortfall risk, using FIREcalc. To do this, you will need the current amount of money you’ve saved towards the goal, along with estimates of (1) the total amount of money you need to reach your goal, (2) the amount of money you plan to save annually, (3) the number of years you are giving yourself to achieve the goal, and (4) the asset allocation you plan to use to reach your goal. The latter three FIREcalc inputs (annual savings, number of years, and investment mix) need only be rough estimates, as you will be using them only as initial starting point for the development of a savings/investment plan that will yield an acceptable level of risk.
After you’ve tested your initial savings/investment plan, using FIREcalc and the procedure I outlined in last month’s post, the next step is to decide whether the resulting risk estimate is acceptable or unacceptable based on the importance of the goal to you. Here you will want to keep in mind that you can choose to increase the risk (and thereby reduce the amount of money you need to save) as well as reduce the risk. There is a tradeoff between your level of shortfall risk and the sacrifices you must make to reach your goals; the less crucial your goals are to your well-being, the more you may be willing to accept a higher risk of a shortfall in return for a reduction in your savings rate.
If you decide that the risk level shown by FIREcalc for a particular goal and savings/investment plan is acceptable to you, then all you need do is implement the plan “as is” (and then return to FIREcalc every one or two years to see if you need to tweak your plan to stay on track). If, however, your estimated shortfall risk is either too high or too low for your comfort, you will need to make modifications to your plan to get your shortfall risk into your comfort zone. Modifications can be made in one or more of three areas: (1) your goal; (2) your savings plan; and/or (3) your asset allocation. In next month’s post (which will appear August 1), we’ll look at how you can use FIREcalc to help you choose the best set of modifications in these areas.