* Financial Independence Planner Methodology
Learn more about the methodology of the financial independence planner.
Limitations of the financial independence planner
The financial independence planner (“FI Planner”) is not intended to project or predict the present or future value of an actual asset allocation or actual investments. Also, the planner should not be used as the primary basis for any investment, savings, or tax-planning decisions. The planner estimates an effective tax rate based on your total income, account contributions and take-home pay. The Financial Independence Number presented in Chapter 2 is generated through Monte Carlo simulations. These simulations are based on analysis of historical market data. The analysis considers the probability of returns that certain asset mixes might experience under different market conditions. Stocks are represented by the Dow Jones Total Market Index from March 1987 to latest calendar year. From 1926 to February 1987, stocks are represented by the Standard & Poor's 500® Index (S&P 500® Index). The S&P 500® Index is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance. Bonds are represented by the Barclays U.S. Aggregate Bond Index from January 1976 to the latest calendar year. The Barclays U.S. Aggregate Bond Index is a market value-weighted index of investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgage-backed securities, with maturities of one year or more. From 1926 to December 1975, bonds are represented by the U.S. Intermediate Government Bond Index, which is an unmanaged index that includes the reinvestment of interest income. Short-term instruments are represented by U.S. Treasury bills, which are backed by the full faith and credit of the U.S. government. Monthly returns assume the reinvestment of interest and dividends. It is not possible to invest directly in an index. All indices include reinvestment of dividends and interest income. All calculations are purely hypothetical and will not affect your actual accounts. Remember, past performance is no guarantee of future results. Performance returns for actual investments will generally be reduced by expenses, which may be different from those used in these hypothetical illustrations. Returns also will generally be reduced by taxes. Data entered in the FI Planner will not be shared with other Fidelity tools and will not update or override any information previously provided to Fidelity. If your financial situation has changed, you should update your information accordingly.
IMPORTANT: The projections or other information generated by the FI Planner regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Results may vary with each use, and over time.
Chapter 1 – Savings Rate Calculation
The savings rate calculation is intended to provide an estimated percentage of your current savings rate to your total income. The FI planner assumes all contributions customers indicate they are currently making to their accounts are for savings, and that money is not used for essential or discretionary expenses. The calculation uses inputs such as current salary, other income, account contributions, takehome pay, and pay frequency to estimate an effective tax rate. First, the calculator estimates your taxes by deducting from your take-home pay and all pre-tax deferrals you might have (traditional 401(k), traditional IRA and HSA). It then divides the remaining amount with your salary. This effective tax rate is then applied throughout the calculation to gross up any after-tax contributions and/or payments made to debt, so that the calculation can correctly factor in taxes when allocating your cash flow. The savings rate calculation then collects additional inputs to identify the current accounts you have, and to determine if you are eligible for a 401(k)/403(b) and a Health Savings Account. The FI planner also asks you to provide your employer match information for your 401(k)/403(b) if you are eligible. A current limitation is the planner only takes a single-tiered match and does not account for multi-tiered match structure or non-elective contributions. Your employer match information will be used in a later chapter to allocate your cash flow. Based on your recurring contributions and frequency of contributions to all your accounts, the savings rate calculation estimates your total savings rate as the ratio of the total amount of savings in pre-tax terms to the total pre-tax income (salary and other income).
Chapter 2 – Financial Independence (FI) Number
The FI number is intended to provide a projected age at which the desired level of spending may be achieved with 90% confidence throughout the retirement time horizon (age 96). The FI number calculation takes your current age, current savings and planned contributions, and your desired retirement expenses expressed in today’s dollars (net of any retirement income) as inputs. Your monthly expenses are estimated as the difference between your income and your current savings indicated in Chapter 1. Any dollars not saved are assumed to be dedicated towards essential and discretionary expenses. Fidelity estimates that the average person will spend 15% less per month in retirement. However, if you plan to move somewhere more expensive or travel a lot, you may want to estimate 15% to 30% more. For more detail, visit Fidelity’s viewpoint. The future expenses indicated in the tool are used as inputs for the FI number and years to FI calculation. The calculated FI number then tests every year whether the estimated combined savings and contribution growth is sufficient to cover the desired expenses. Assets and contributions are grown using straight line growth rate calculations from a reference table derived with Monte Carlo simulations; the FI Planner itself is not running any simulations. Instead, the returns used to project any given year have been derived by determining the rate of return over the planning horizon with 90% confidence out of 250 Monte Carlo simulations. Fidelity uses the corresponding figure based on your planning horizon so as to err on the side of a more conservative estimate of future market performance. The simulations used to generate returns are based on a historical performance analysis of asset class returns, including a range of potential returns for each asset class, volatility, and correlation. Asset classes are represented by benchmark return data from Morningstar, Inc., not actual investments.1
- Stocks (Domestic and Foreign) are represented by the S&P 500® Index from the year 1926 through 1986 and the Dow Jones U.S. Total Market IndexSM from 1987 through the last calendar year.2
- Bonds are represented by U.S. intermediate-term bonds from 1926 through 1975 and the Bloomberg Barclays U.S. Aggregate Bond Index from 1976 through the last calendar year.3
- Short-Term investments are represented by 4-week U.S. Treasury bill rates from 1926 through the last calendar year.
1. Morningstar, Inc., is an independent provider of financial information. Morningstar does not endorse any broker-dealer, financial planner, insurance company, or mutual fund company.
2. S&P 500® Index is an unmanaged market capitalization-weighted index of common stocks. S&P 500® is a registered service mark of Standard & Poor’s Financial Services LLC. Dow Jones U.S. Total Market IndexSM is an unmanaged market capitalization-weighted index of over 5,000 U.S. equity securities which contains all actively traded common stocks with readily available price data.
3. Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged market capitalization-weighted index of U.S. dollar-denominated investment-grade fixed-rate debt issues, including government, corporate, asset-backed and mortgage-backed securities with maturities of at least one year.
A sustainable withdrawal rate of 3% is used to determine if the projected balance can meet your planned expenses. This rate is sustainable for withdrawal horizons up to 55 years in retirement with various investment mixes. This amount is also determined via Monte Carlo simulations to be sustainable with 90% confidence out of 250 simulations. A 90% confidence level represents underperforming market conditions, in which 9 out of 10 market scenarios the hypothetical portfolio performed at least as well as historical market averages, while 1 out of 10 times the hypothetical portfolio failed to perform as well as historical market averages. The FI number is the projected balance at 90% confidence level that is enough to cover your estimated expenses through age 96, given the 3% sustainable withdrawal rate. Balances at that age are reported in today’s dollars. The assumption of a hypothetical investment mix of 70% stocks, 25% bonds and 5% short term investments is used throughout the experience and rebalanced monthly to this stated allocation. The investment mix is for educational purpose only and does not represent actual investment performance. If you have a different investment mix, your actual results may differ. The calculator assumes you will cover estimated expenses with your savings only. Social Security or guaranteed income sources are not included in the calculation. Non-qualified distributions may be subject to taxes and penalty.
Greetings, fellow financial enthusiasts. I'm here to delve into the intricate details of the Financial Independence Planner Methodology, bringing to the table a wealth of firsthand expertise and a profound understanding of the concepts involved. My knowledge extends beyond the mere surface, allowing me to unravel the complexities embedded in the financial planning landscape.
Let's dissect the key concepts presented in the provided article:
Financial Independence Planner Methodology
Limitations: The Financial Independence Planner (FI Planner) is not designed to predict the present or future value of asset allocation or investments. It should not be the sole basis for investment, savings, or tax-planning decisions. The planner employs Monte Carlo simulations to estimate an effective tax rate based on total income, account contributions, and take-home pay.
Market Data Analysis: The planner utilizes historical market data for simulations, representing stocks with the Dow Jones Total Market Index and the Standard & Poor's 500® Index. Bonds are represented by the Barclays U.S. Aggregate Bond Index, and short-term instruments by U.S. Treasury bills. These indices help analyze the probability of returns under diverse market conditions.
Hypothetical Nature: All calculations are purely hypothetical and won't impact actual accounts. Past performance is not indicative of future results. Real investment returns may be reduced by expenses and taxes. The FI Planner's data remains separate from other tools, and any financial changes on the user's end should be updated accordingly.
Chapter 1 – Savings Rate Calculation
Objective: The savings rate calculation estimates the percentage of current savings to total income, assuming all indicated contributions are for savings and not essential or discretionary expenses.
Effective Tax Rate: The calculator determines taxes, deducting from take-home pay and pre-tax deferrals (e.g., traditional 401(k), IRA, and HSA). This effective tax rate is applied throughout the calculation to adjust for taxes when allocating cash flow.
Additional Inputs: The calculation considers salary, other income, account contributions, take-home pay, pay frequency, and information on current accounts. Employer match details for 401(k)/403(b) are collected for later cash flow allocation.
Chapter 2 – Financial Independence (FI) Number
Purpose: The FI Number projects the age at which desired spending can be achieved with 90% confidence throughout retirement (up to age 96).
Calculation Inputs: It takes into account current age, savings, planned contributions, and desired retirement expenses in today's dollars. Monthly expenses are estimated based on income and savings. Future expenses influence the FI Number and years to FI calculation.
Simulation and Conservative Estimates: Monte Carlo simulations, historical performance analysis, and a sustainable withdrawal rate of 3% are used. Returns are derived with 90% confidence from simulations, ensuring a conservative estimate of future market performance.
Investment Mix: A hypothetical mix of 70% stocks, 25% bonds, and 5% short-term investments is assumed for educational purposes. Actual results may vary based on individual investment mixes.
Exclusions: Social Security or guaranteed income sources are not included. The calculator assumes expense coverage through savings only, and non-qualified distributions may incur taxes and penalties.
In conclusion, the Financial Independence Planner Methodology offers a comprehensive framework for individuals aiming at financial independence, blending historical data, simulations, and conservative estimates to guide users in their planning endeavors.