4 dangerous assumptions that could hurt your…
As avid watchers of sitcom reruns (and a real Felix/Oscar combo), my sister and I loved it The odd couple while we were growing up. One of our favorite episodes featured a courtroom sequence in which Felix (Tony Randall) berates a witness to “never assume” and uses the board to demonstrate what happens when you do. More years later than I care to admit, the mere mention of the word “assume” makes me smile.
But guesswork isn’t always a laughing matter, and that’s certainly true when it comes to retirement planning, where “hope for the best, plan for the worst” is a reasonable motto. Incorrect – and usually too rosy – retirement planning assumptions are particularly problematic because, by the time a retiree or pre-retiree realizes that her plan is in trouble, she may have few ways to fix it; spending less or working longer may be the only viable options.
Here are some common — and dangerous — assumptions people make when planning for retirement, and some steps they can take to avoid them.
Dangerous assumption 1: That stock and bond market returns will be robust
Most retirement calculators ask you to estimate how your portfolio will perform over your holding period. It can be tempting to take advantage of high returns to avoid tough choices like postponing retirement or spending less, but think twice.
Admittedly, the long-term gains in equities have been quite robust. The S&P 500 has generated annualized returns of more than 10% from 1926 to the end of last year, and returns over the past 15 years have been similar. But there have been certain periods in the history of the market when returns have been much lower than that; in the decade that ended in 2009, for example – the so-called “lost decade” – the S&P 500 actually lost money on an annualized basis.
The reason for the weak performance of stocks during this period is that they were expensive in 2000, at the beginning of the period. Stock prices aren’t in Armageddon territory now, but they aren’t cheap either. The Shiller P/E ratio, which takes cyclical factors into account, is currently at 37, versus a long-term average of less than half that number. Morningstar’s price/fair value for companies in its equity coverage universe is much less scary at 0.97, indicating stocks are fairly close to fair value. But few expect bonds to perform well, given that starting yields have always been a strong predictor of bondholder returns.
What to do instead: These valuation measures suggest that cautious investors should lower their market return projections somewhat just to be safe, at least for the next decade, and this has implications for retirement planning. In our recent research on retirement income, for example, incorporating very modest return expectations for stocks and bonds resulted in a safe starting withdrawal percentage in the low 3% range. But we also explored ways to increase that starting percentage, including using some spend variability.
Dangerous assumption 2: that inflation will be benign
For most of the past two decades, inflation has not been a problem, with the consumer price index rising only 2% or less in most years. This made inflation easy to ignore or at least minimize when forecasting retirement spending. However, recent events illustrate the danger of assuming that consumer prices would remain in a steady state, as the latest CPI reading showed an increase of nearly 8% for the year ending February 2022. If inflation remained high, retirees have to withdraw more than expected from their wallets just to maintain their standard of living. Bill Bengen, the author of the original research on the “4% guideline”, expressed his concerns about this very issue when we interviewed him in December 2021.
What to do instead: Rather than assuming inflation will stay good and low in the years leading up to and during retirement, investors should use longer-term inflation numbers to guide their planning decisions. Although it seems unreasonably pessimistic to assume that the currently high inflation readings will persist in perpetuity, 3% or even 4% is a reasonable starting point. And whenever possible, investors should tailor their inflation forecasts to their actual consumption baskets. For example, health expenditures often represent a larger share of expenditures for many retirees than for the general population, while housing expenditures may represent a smaller component of total expenditures for retirees, especially if they own their own House.
The possibility that inflation could be higher during your retirement than it was from 2000 to 2020 also argues for putting hedges in your retirement portfolio to help preserve purchasing power. once you start spending your retirement assets. This means equities, which have historically had a better chance of outpacing inflation than any other asset class, as well as inflation-protected Treasuries and I-Bonds, commodities, metals stocks precious and real estate. It also argues against excessive holding of fixed rate investments that have negative return potential once inflation is taken into account.
Dangerous assumption 3: that you will be able to work after age 65
No matter how you feel to work longer: The financial merits are irrefutable. Ongoing portfolio contributions, delayed withdrawals, and late Social Security filing can all greatly improve the sustainability of a retirement portfolio. Given these considerations, along with shrinking pensions, increasing longevity, and the fact that the financial crisis has impacted the portfolios of many pre-retirees, it’s no surprise that older people are pushing back their planned retirement dates. . While only 11% of respondents to the Employee Benefits Research Institute’s 1991 Retirement Confidence Survey said they planned to retire after age 65, that percentage had more than tripled – to 39% – in the 2021 survey.
Yet there seems to be a disconnect between pre-retirees’ plans to delay retirement and whether they actually do so. Forty-six percent of workers leave the labor market earlier than expected, according to a study by EBRI. Some of this divergence, especially recently, may be due to expanded portfolio balances, the result of an extended stock run. But health considerations (those of the worker, spouse or parents), unemployment or the unbearable physical demands of the job likely play a role for some.
What to do instead: While working longer could earn you three times as much for your retirement plan, as noted above, it’s a mistake to assume you’ll be able to do so. If you’ve crunched the numbers and it looks like you won’t be successful, you can plan to work longer while pursuing other measures, such as increasing your savings rate and reducing your planned expenses. retired. At a minimum, reduce your income projections after age 65 to account for the possibility that you may not be able – or choose not to – earn as much income in your later years as you did in your lifetime. the years when income is highest.
Dangerous assumption 4: that you will receive an inheritance
It’s a convention in movies that kids get discouraged when their parents don’t leave them an inheritance, and a few studies show there can be a disconnect between what kids expect to receive and their possible windfalls. . While around 70% of millennials surveyed by Natixis say they expect to receive a windfall, only 40% of their parents plan to leave one. A Schwab survey identified a similar disconnect between heir expectations and reality. Increasing longevity, combined with long-term care needs and rising long-term care costs, means that even parents who want their children to inherit assets from them may not be able to able to do so.
Adult children who expect an inheritance that doesn’t materialize may be prone to overspending and undersaving during their peak years. And by the time their parents pass away and don’t leave them a windfall — or leave them much less than they expected — it might be too late to make up the shortfall.
What to do instead: Do not rely on unknown unknowns. If you’re incorporating a planned inheritance into your retirement plan, it’s wise to start communicating about it as soon as possible. Alternatively, if you don’t want or need an inheritance but suspect your parents are forgoing their own consumption to give you one, you can have this conversation as well.