The typical way in which retirement computations are done is broken. Calculating the corpus you need for funding your retirement is not as simple as it is made out to be. This tool has been built to illustrate this point.
Using this tool, you can calculate the required retirement corpus using two methods,
You can first calculate the required retirement corpus using the Deterministic Approach. To check whether this corpus will really be enough, you can run simulations on this corpus to check for its adequacy using the Testing Adequacy page.
In most cases, you would see that the corpus calculated using the Deterministic Approach shows a high failure rate when tested for adequacy. This testing is done using simulations with historical market data.
You can then calculate the required retirement corpus using the Stochastic Approach. This approach will give you more accurate results as it takes into account volatility in future asset returns and inflation.
In the Deterministic page, you can calculate the retirement corpus by providing inputs for equity return, debt return, inflation, retirement period and equity allocation. If you have previously used a typical retirement calculator, you would be familiar with these inputs.
The critical flaw in this approach is that it assumes that asset returns and inflation are predictable. This is why this approach is called 'deterministic', as it assumes that the future is determinable and predictable. Unless you have a crystal ball, this is not a good assumption.
Another problem with the Deterministic Approach is that it assumes that your retirement portfolio will earn the same equity returns, debt returns and inflation each year. Reality will be very different. Each year, your retirement portfolio will face different equity returns, debt returns and inflation. This is called the Sequence of Return Risk, and without factoring this risk, you cannot accurately calculate the required retirement corpus.
A better method to estimate the required retirement corpus is to use the Stochastic Approach. A stochastic method will not provide a single outcome, but a range of possible outcomes. In this approach, your retirement portfolio is put through different scenarios of equity returns, debt returns and inflation to check if it is able to last for the full retirement period.
Using the technique of Monte Carlo Simulation, thousands of simulations are run using historical data of equity returns, debt returns and inflation to check for the adequacy of a retirement corpus.
This is a superior approach to calculate the required retirement corpus which you can explore via the page Stochastic.