People who have retired in the last 5-10 years are facing daunting challenges. They have seen the value of their homes and their retirement portfolio plummet while the cost of insurance and daily living continues to rise. Adding to their frustration is that the financial planning (upon which they based their decision to retire) indicated that they should be able to live comfortably the rest of their lives. I believe that those financial plans are failing because they were based on erroneous assumptions. Unless retirees recognize that and make the proper adjustments, they risk running out of money well before their life expectancy and becoming dependent on their children and/or the government to meet their basic needs.
Traditional financial planning is based on the assumption that the future will bear some resemblance to the past. The rates of return used in the plans are based on the historical returns associated with each class and category of investments. For example, the return and expected volatility (risk) of large cap value investments is based on what has occurred the past 30 years. Supposedly, that is a large enough sample to cover the majority of likely outcomes. So the overall return of your expected portfolio is based on historic performance.
This approach worked well for many years—until it didn’t. I believe the traditional assumptions no longer hold true and that financial planning needs to include situations and market conditions that previously had a very low probability of occurring. Why should they be used? Because these ‘tail events’ are what pose the greatest risk to the overall success of the financial plan. It’s these ‘tail events’ that are going to result in those that retired in the last decade running out of money years, even decades earlier than what they thought.
For example, traditional financial planning still estimates an average annual return for equities of 10% or greater and average annual returns for bonds at over 5%. Even if they assume variable rates of return the results are going to be skewed because of the underlying assumption that long-term results will equal historic results. Recently I ran a retirement income stress test (an innovative process I’ve developed) on the retirement income plan of someone with a $1.3 million portfolio. The traditional planning software gave his plan a 99% probability of success! Of course, it assumed an average annual rate of return that far exceeds anything he has earned the last 5 years. That means that he will need to earn far in excess of 10% a year to make up for the last five years and get back on track.
Using what I (and most retirees) consider more realistic rates of return, the probability of success dropped from 99% to only 8%. There was a 91% DECLINE in the probability of success just by assuming an annual return in of 5% instead of 10%. Fortunately, this person found out this sobering news while he still has time to do something about it. By adjusting the way he is invested and how it is managed, we have been able to significantly increase his probability of success even if returns remain as they have been the last 5 years. He doesn’t have to make drastic changes to his lifestyle.
What about you? Do you know the probability of your retirement income plan running out of money before your life expectancy? If you are basing your expectations on a traditional financial plan and its lofty assumptions, you may want to see the impact of more realistic return assumptions while you still have time to adjust. Realistic, and flexible, financial planning is key to success. Thanks for reading.
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