Posted by: ryanmccoskey | June 2, 2009

5 Reasons to Fear the Financial Calculator

If you have financed a house, allocated your 401(k) or worked with a financial advisor, then you’ve probably been exposed to the wildly popular “financial calculator.” For those who haven’t had such pleasure, allow me to explain.

A financial calculator is a relatively simple tool. In short, it’s a process by which someone attempts to project future results based on current assumptions. Let’s take a new home buyer as an example. If someone wanted to project their monthly payment on a new home, they could use a mortgage calculator, which is a type of financial calculator (you can find mortgage calculators all over the internet). They could input the purchase price, insurance, taxes, term length and interest rate to project their monthly principal and interest payment. It’s really quite simple. By using this tool, the home buyer can make an educated decision about how much home he or she can reasonably afford.

In the case of the mortgage calculator, there isn’t much ambiguity; in other words, the buyer’s experience will most likely be quite similar to the calculator’s projections. However, in this regard, the mortgage calculator is unique.

Perhaps the most widely utilized financial calculator is the retirement planning calculator. It operates much like the mortgage calculator – someone can input how much money they need for retirement, their mix of stocks and bonds, the inflation rate, how long they will live, their tax bracket, and their current savings. In turn, the calculator spits out the annual contribution required to meet those retirement needs.

It all seems pretty logical, right? You get on the internet, put in the numbers, click the “calculate” button, and then watch your retirement plan / college savings plan / investment plan come to life. Or perhaps you go to a traditional financial planner who charges you money to do the same thing – sure they dress it up for you, but at the core, a traditional planner uses the same calculators you would find on the world wide web.

But wait a second!

Is it really that simple? Maybe you’ve heard the expression “life happens.” So my question is: What happens to the calculator’s projections when “life happens?”

For the remainder of this article, we’ll be looking at five key reasons why financial calculators are both unhelpful and harmful.

1. Assumptions Change

This is the most obvious problem with financial calculators. Interest rates, market prices, the inflation rate, your income, your tax bracket and your income needs are always changing. In fact, a traditional plan drafted even one year ago may already be obsolete. Thus, any time even one thing changes, the whole plan needs to be updated. However, calculators can’t be blamed for this. No tool can predict the future, and no matter how hard you try to avoid change, you won’t succeed. Nonetheless, calculators are weak in this regard because the numbers you input remain constant for the entire calculation.

2. Calculators always supply the minimums

What if you need more retirement income than you think? What if the market tanks 2 years before retirement and your annual contribution over the last 20 years wasn’t enough? What if you have an emergency and need to access some of your retirement capital? These are very reasonable questions that financial calculators cannot answer. The problem with all of these scenarios is that calculators recommend the minimums. Therefore, any negative change in the variables renders the plan a failure. In other words, the plan only works under a single set of circumstances – is that thorough planning? In this regard, financial calculators can be very harmful. Ask yourself: In a world of constant change, is it wise to shoot for the “minimum needs” in your retirement funding / college funding / investment strategy?

3. Math and money are not interchangeable

In mathematics the value of a number remains constant. However, numbers in money don’t hold a constant value. Because of inflation and changes in currency values, money does not remain stable. Thus, financial calculators perform linear equations with mathematical numbers. But money, on the other hand, does not always work like math. This is another reason why financial calculators can be misleading. Life and money are not abstract constants like math.

4. No financial decision is an island unto itself

This is perhaps the most overlooked problem with financial calculators. Each time you make a financial decision, there are a multitude of things that change. For example, if someone was looking to refinance a house, the mortgage calculator could be utilized. And by using it, the homeowner can project their new payment. But there’s so much more to consider. What about the change in the interest portion of the payment? How will that affect taxes? In turn, how will that affect savings? Will any equity be carved out? If so, how is it to be used? How close is the homeowner to retirement? How will the new mortgage deduction affect tax liability on qualified money?

Each portion of your financial landscape does not stand alone – everything is connected to everything else. If you make a change in one place, it will affect the performance of everything else. But calculators can’t account for that. Therefore, financial calculators and traditional financial planning can lead to mass inefficiencies in your overall plan.

5. Calculators only give you numbers, not strategies

Reducing your financial planning efforts to “how can I create the biggest number” is a damaging mistake. Once again, money and math are not the same. Calculators only show you how to get a bigger number; but they have nothing to say about tactical strategy. The account or market value of something means nothing in the long run. What counts is spendability, versatility, reliability, and accessibility. Calculators have nothing to say about any of these issues.

In conclusion, I find it remarkable how many advisors are still basing their recommendations on what a financial calculator spits out. The full financial landscape must be considered in order to develop successful solutions to complex problems like retirement and college funding. In this regard, I think Benjamin Frankling has something relevant to say: “By failing to prepare, you are preparing to fail.”

Thanks for reading and good planning. Click the “What I Do” tab at the top of this page for further information.

Is this the basis of your plan?

Is this the basis of your financial plan?


Responses

  1. Who is Benjamin Frankling? 🙂 Very informative blog. Nice work!


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