The right math for your nest egg

NEW YORK (Money) -- Question: Why is it that most retirement calculators don't factor in the fact an investor would normally transition into bond and money market funds as retirement approaches? Moreover, few articles address how a flat or declining market in the year before retirement could affect the size of one's nest egg. What's an investor to do? - Peter Binoto, Pittsburgh, Penn.

Answer: Before I answer your question, I want to point out that not all calculators assume you won't gradually shift your assets into bonds as you approach retirement.

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For example, if you go to the What You Need To Save calculator on our Web site and punch in your age, salary and the amount of money you have saved, you'll get an estimate of how much you need to save each year until retirement.

If you then look at the notes section immediately below the estimate, you'll see that, among other things, the calculator assumes that your savings are invested much like the assets in a target-date portfolio fund - that is, as you get older, the portfolio becomes more conservative, in this case moving gradually from 91 percent in stocks at early ages to 46 percent in stocks by retirement.

But I agree that you raise a very important point for anyone who uses financial planning software or online calculators to help them with their retirement planning. If you want to really understand the results you get from a calculator, you've got to take a look at the underlying assumptions.

If it assumes a rate of return or a mix between stocks and bonds that doesn't reflect the way you actually invest your retirement assets, then you've got to consider to what extent, if any, the results are meaningful for you.

That said, however, it's also important to remember that no calculator is going to be a perfect match for everyone, or even any one person for that matter. Every person's financial life is a little bit different. Going back to our "What You Need To Save" calculator, for example, it also assumes that you'll want to retire with 80 percent of your pre-retirement salary after deducting the amount you save each year.

Clearly, some people may need a higher percentage of their pre-retirement income, while others may require less. I suppose someone could build a calculator that allows each person to customize every single factor and variable to his or her liking. But that could get daunting and turn away people who want a relatively quick check-up on how they're doing.

And even people who might be willing to slog through the details might not know what assumptions make sense in some cases, such as what percentage of their mutual fund's returns they should assume come in the form of qualified dividends vs. short-term capital gains vs. long-term capital gains.

All of which is to say that you've got to approach any calculator or software program with a realistic attitude. No matter how sophisticated it is, it's still only going to give you an estimate, an approximation, of how things might turn out. A calculator can't predict future investment returns, or the ebbs and flows of the economy, or know whether Congress will change tax rates or whether you'll stick to the savings and investment regimen that you plug in.

That's why it's a good idea whenever possible to run several scenarios whenever you're using a calculator or software program. Assume a lower rate of return, a more aggressive or conservative mix of assets, maybe change your planned retirement date. Doing this can give you an idea of the range of possible outcomes - and allow you to adjust your planning so you'll come out okay even if things don't work out exactly as you would like.

And since things change - investment markets, your job situation, your finances, expected retirement date, your health, etc. - you should also re-run the numbers at least every couple of years. Better to do some fine tuning to your saving and investing plan along the way than to find out a few years before retirement that you're nowhere close to the course you set 10 years ago.

And speaking of those years just before retirement, your point about the effect of a flat or declining market is right on. Suppose, for example, that you were ready to retire in January 2000 just before the bear market and had a 401(k) nest egg of $500,000 invested entirely in stocks.

Well, over the next three years your 401(k) balance would have declined about 38 percent, bringing its value to about $310,000. Had you held a more conservative mix of 60 percent stocks-40 percent bonds (and rebalanced back to that blend each year), you would have taken a smaller hit of about 12 percent, leaving you with a $440,000 balance.

Of course, we can't tell in advance when the markets are about to take a spill. Which is why you need to gradually move more of your portfolio from stocks into bonds and cash as you near retirement. You still want to maintain some stock exposure for growth that will help you maintain your purchasing power. But you also need stability so that the combination of market setbacks and withdrawals from your portfolio for living expenses doesn't deplete your savings too soon.

So what's an investor to do? Well, I think the best answer starts with an admission that you'll never be able to forecast your route to retirement - or your path once you get there - with anything close to 100 percent accuracy. So factor that into your planning by considering several different scenarios and building in a safety margin. Save a little more than you think you need to and be flexible about your retirement date or about working a bit in retirement.

Similarly, don't put yourself in a position where a market downturn on the eve of retirement can totally scuttle your plans. By gradually moving toward a more conservative mix of stocks and bonds as you age, you'll get the growth you need but you'll also be better able to protect the nest egg you've accumulated over the course of your career. (For an idea of what your portfolio might look like at three different stages of your career, click here.)

And if you're not confident about your ability to do this sort of planning on your own, then you might want to consult an adviser. (For a column I wrote on how to do that, click here. If you'd like to see a video on that topic, click here.)

You can't control the future. Unexpected things will happen. But the better you position yourself ahead of time to absorb potential setbacks and respond to changing conditions, the greater the chance you'll be able to retire when you want, the way you want.