You Know What They Say About Assumptions
You know what they say about assumptions. But still we persist.
The uncomfortable fact is that any financial plan — and a long-range retirement plan especially — is built upon a plethora of what-ifs that may or may not prove true. Absent a crystal ball, no one can tell you if your retirement plan is 100% foolproof. The best we can do is make reasonable assumptions about how the future will play out, monitor the worthiness of these assumptions over time, and update as necessary.
In the retirement planning world, one is often confronted with a Monte Carlo simulation. In plain English, this is a way to illustrate how long your retirement nest egg will last under a variety of different investment market conditions. The goal is to respond to that common question, “Will I run out of money?” It’s a perfectly fine approach as far as it goes…but investment returns are only one component of your retirement plan.
Let me describe to you how I make my sausage. Whenever I sit down to create a retirement financial projection for a client, these are the factors that I make assumptions about:
Your Future Contributions to Your Retirement Savings. Hands down, this is the most important assumption. Luckily, it is the one that is most in your control. And while there are rules of thumb out there about how much you should contribute to a retirement account, I prefer to take a more considered approach, basing your “ideal” savings rate on an assumption about…
Your Plan for Spending in Retirement. For someone who is decades away from retiring, this is perhaps the fuzziest of the assumptions. But we must make an educated guess. My usual strategy is to consider that few people envision a retirement lifestyle that will cost substantially less than what they spend now. (And if they are in their 20s or 30s, their vision may be to have a much costlier lifestyle in their 60s.) The composition of how you spend your money changes in retirement, but the overall total does not usually fall very much, especially in the early years. Current spending is my usual assumed starting point, at least to get the conversation going.
Rate of Return on Investment Portfolio. In creating projections, I pretty much always assume a 6% rate of return. Yep, this is less than what the stock market has been returning in recent years (2022 excepted), but I don’t assume that a client will always be fully invested in stocks. I also don’t assume that the high stock market returns we have seen in recent years will always persist. It’s a conservative number based on the historic return of a balanced portfolio of both stocks and bonds, and one that I am comfortable using in my estimations.
The 4% “Rule.” So much ink has been spilled discussing the 4% so-called “rule.” This is the amount, based on research, that you can “safely” withdraw from a balanced portfolio of savings each year (adjusted for inflation) with little risk of running out of money, assuming a typical 30-year retirement. While some argue that the percentage should be a bit lower, and others argue that it should be a bit higher (as it is an inherently conservative figure that yields a great deal of “leftover” after 30 years under any normal market scenario), for long range planning purposes I find that it is a good starting point to assess if, generally speaking, one is on track to have saved enough for retirement.
Long Term Care Costs. A financial plan that does not include the possibility of long term care costs is not a plan at all. Your plan may be to seek long term care insurance, to self-fund the cost, use Medicaid…or some combination of these strategies. Regardless, the starting point is understanding the possible cost; for that I rely on the CareScout (née Genworth) long term care cost calculator.
Inflation. If it’s good enough for the Federal Reserve, it’s good enough for me. When I want to project how much a client will want to spend in the future, I use the Federal Reserve 5-Year Breakeven Inflation Rate. Monthly CPI rates can be pretty herky-jerky; this is what the Fed looks to when it thinks about what inflation may look like over time.
Social Security. I realize that there is a school of thought out there that believes that one should not include any estimate of Social Security in their future planning, based on the rather nihilistic view that the system is irrevocably broken and unlikely to exist in the future. Well, my assumption is that it will exist. Yep, there will be changes in the benefit formula along the way. If someone wants to save more based on their belief that they will never capture a Social Security benefit, I’m fine with that. That’s your choice. But I am going to estimate what I think your benefit will be anyway.
Income Tax Rate. TBH, I don’t expend a lot of gray cells on this assumption. Yes, I look at what one’s likely income stream will be in retirement and discount that for taxes under current rules. But honestly, who knows what tax rates will be 20 years from now? Or even ten. My philosophy is that the success or failure of your retirement plan is not going to hinge on an assumption about future tax rates.
A retirement plan is no better than the assumptions upon which it rests. The goal is not to have a perfect vision of the future, but rather to understand what the moving parts are so that as you edge closer to retirement, you can adjust your expectations accordingly.
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