Are retirement calculators reliable?

(Money Magazine) -- Based on my age, investments and the amount I'm saving, an online calculator suggested that my chances of being able to retire with the money I'll need is a virtual slam dunk. How confident can I be that my investments will actually earn enough over the next 40 years for me to retire? -- D. M.

I'm not a math wiz or a quant by any stretch of the imagination. But when it comes to making retirement planning decisions, I think it's important to look at the numbers.

That said, whenever you rev up an online tool or calculator, you've got to remember that you're dealing with estimates (often very squishy ones) not certainties. So common sense dictates that you take the results with more than a couple grains of salt.

Let's take the case of retirement calculators. Most project how large a nest egg you might accumulate -- and, in many cases, how long it might last -- based on a number of factors, including how much you've already accumulated, how much more you plan to save, how many years until you retire, the rate of return your investments will earn and how long you'll live.

You don't need a finance degree to know that all of these factors involve more than a little uncertainty. It's one thing to say you plan to save $500 a month or 15% of your salary for the next three or four decades and plug that assumption into a calculator.

It's another thing to actually do it. Reality often intrudes. Companies downsize, kids need orthodontia, college bills zap savings and sometimes the will to save yields to the urge to spend.

Projecting investment returns doesn't exactly lend itself to precision either. Forecasters generally start with a long-term expected return that builds in some variation -- both up and down -- since it's clear that investments like stocks and bonds don't churn out identical returns year after year.

See if you've saved enough for retirement

Typically, the expected return is based on historical average returns for various asset classes or projected averages based on how returns might unfold given today's conditions.

Either way, there's as much art as science in determining this, as even when you're dealing with historical data, averages can vary substantially depending on the period you choose.

For example, the bible for investments stats, the Ibbotson SBBI Classic Yearbook, shows that from 1926 through 2010, the annualized return for large-company stocks was 9.9%. But there were many relatively long stretches over that span when stocks' annualized return was much higher (20.1% for the 10 years from 1948 through 1958) and much lower (-1.4% for 1999 through 2008).

[Note to purists: I know that investment firms use arithmetic averages, not geometric averages or annualized returns, to build forecasts. But individual investors are more accustomed to seeing annualized rather than arithmetic returns -- which for stocks would be considerably higher -- so I cite annualized figures to avoid confusion.]

Investing when 'paralyzed with fear'

My point is that, even people who take a meticulous approach can come away with different ideas of what investments might earn in the future. That's the nature of prognostication.

At the same time, you must also be careful of falling into the "recency" trap, or basing your estimates on what's happened lately. It would be just as wrongheaded to presume the rough times we're experiencing today represent our long-term future as it was to assume (as many did at the time) that the boom times of the '90s marked the beginning of a golden era of unabated prosperity.

And, indeed, most rigorous attempts to forecast returns try to avoid merely accepting past averages or extrapolating recent experience into the future. (For a look at how two recent forecasts do that, click here and here).

So what does all this mean for someone trying to get a handle on his retirement planning? It's great to come away from a session with a retirement calculator with good news.

But just to be on the safe side, do a little reality check. Maybe try another calculator to see if the results are at least in the same ballpark. I'd also advise running a few different scenarios to see how that affects the results.

Send Walter Updegrave a question

A young person like you with some 40 years to go until retirement probably has a relatively aggressive investment portfolio, say, 80% or more in stocks. If that's the case, try re-running the numbers with more conservative mixes, say, 60% stocks - 40% bonds or even 50% stocks - 50% bonds.

You'll likely find that your odds of success are somewhat lower -- or, that you'll have to boost the amount you're saving each year in order to maintain those better odds of success.

The extent to which the odds drop, shows how much you're counting on the higher expected returns of stocks to achieve a comfortable retirement. If those gains materialize, that's fine. But you don't want your retirement prospects to collapse if those returns fall short.

So to be safe, you may want to set your savings targets based a more moderate investing strategy. Save a bit more so that you're still okay if your investments earn less than the return projected with a more stock-heavy portfolio (or if you happen to miss your savings targets in some years).

And remember that no tool or calculator can predict the future. That's especially true when you're looking decades ahead. Over the 40 years between now and the time you retire there are just too many unknowns. Neither you, nor I, nor anyone else can control how the economy or the financial markets will perform.

What you can do, though, is check your progress periodically -- say, every year or so -- and adjust your overall savings and investing strategy to stay on track as you draw closer to your planned retirement date. Do that, and you can rest assured you are doing all you can.