“Everyone knows that when you make an assumption, you make an ass out of ‘u’ and ‘umption’.”
Samuel L. Jackson's character, Mitch Henessey, had a memorable line in the movie A Long Kiss Goodnight that cleverly conveys the risks associated with making assumptions. In the complex world of retirement planning, we often deal with those hazards as we rely on various expectations of the future to chart possible financial outcomes. These assumptions influence everything, from our savings rates to our investment choices. In this Accountable Update, I explore how we can balance these necessary but uncertain assumptions with the flexibility required to implement an effective retirement plan while adapting to life’s unpredictable changes.
ASSUMPTIONS IN FINANCIAL PLANNING: THEIR ROLE
Assumptions form the foundation of financial planning. They help us build strategies aimed at achieving personal financial goals. When planning for retirement, we assume many of the variables that comprise the plan. Common assumptions include:
How much we’ll spend on our goals.
How long we may live.
Investment returns.
Inflation.
Taxes.
Cost of Healthcare.
These inputs help shape our plans for how much we need to save and invest. However, these assumptions are based on historical data and forecasts about future events, both of which carry inherent uncertainties. Markets, economic conditions, or life itself are unpredictable, necessitating a planning strategy that not only relies on robust financial theories but also adapts to these uncertainties.
IMPACT OF FINANCIAL ASSUMPTIONS ON RETIREMENT PLANNING
Investment Returns: Assuming future investment returns that are too optimistic can lead to lower savings rates than are necessary for achieving your goals. Conversely, using return assumptions that are too conservative might cause individuals to save more than necessary, potentially restricting their current lifestyle unnecessarily or missing out on reasonable investment opportunities.
Inflation: As we’ve seen recently, if actual inflation exceeds the assumed rate, the purchasing power of savings could erode faster than planned, severely impacting retirement living standards.
Longevity: While we frequently focus on the impact of an early death on financial plans, underestimating how long one will live might lead to the frightening prospect of outliving one's savings. With advances in healthcare and increasing life expectancy, planning for a long retirement is more crucial than ever. Modern medicine and healthier lifestyles mean that people are living longer. Planning for retirement should include the possibility of living well into one's 90s (or even longer). For someone retiring around age 60-65, this could mean planning for 30 years or more of retirement living.
Healthcare Needs: As we age, healthcare becomes one of the largest categories of expense. Healthcare costs typically rise faster than general inflation, making it critical to factor in higher costs for medical needs.
Tax implications: Changing tax laws can have a significant impact on retirement savings and withdrawal strategies. Keeping abreast of current and proposed tax legislation can help adjust plans to be more tax-efficient.
Unexpected Expenses: Most of us can probably make a reasonable estimate of what we need to live the lifestyle we are comfortable with. For example, we can look at last year’s credit card statements, bills, and bank balances as starting points to understand our spending habits. However, life has a way of creating unexpected expenses such as healthcare needs, disability, early death, etc.
Global Economic Conditions: The interconnectedness of today's economy is evident. Economic developments in one part of the world can have an impact on global financial markets. Including geographical diversification in your investment portfolio can help mitigate some of these risks.
Addressing these variables with a nuanced understanding of assumptions can lead to a more comprehensive and resilient retirement strategy. Modeling not only the expected outcomes but also including "What If" scenarios in a plan to see the impact of common roadblocks can provide insight into the risk and help inform how to deal with it before there is a crisis.
WE APPLY ASSUMPTIONS STRATEGICALLY IN INVESTMENT PLANNING.
Using assumptions in retirement planning should guide setting up flexible strategies rather than rigid rules. Tools like dynamic asset allocation, which adjusts the investment mix based on current market conditions, can help manage risks and potentially enhance returns. Monte Carlo simulations can model thousands of possible scenarios using a range of assumptions to help understand the risks and probabilities of different outcomes.
PRACTICAL TIPS FOR NAVIGATING RETIREMENT PLANNING WITH ASSUMPTIONS
Maintain Flexibility: Financial plans should evolve with your personal circumstances and the broader economic environment. It's wise to review and adjust your financial plan on an annual basis or after significant life changes.
Use Conservative Estimates: It’s prudent to use conservative estimates for market returns and assume higher-than-average costs for inflation and healthcare. This approach provides a safety buffer, guarding against negative financial surprises.
Stay Informed: Keeping informed about financial news and economic trends can provide early warnings about changes that could affect your investments and retirement planning.
Engage with professionals: Regular discussions with your accountant, doctor, lawyer, or financial advisor can ensure that your retirement planning reflects both current conditions as well as your personal goals and needs.
CONCLUSION
Assumptions are an essential component of planning for retirement, but your approach shouldn't solely rely on them. Understanding their limitations and incorporating a flexible approach can help you navigate the complexities of financial planning effectively. At ATX Portfolio Advisors, we can help “u” and “umption” develop a flexible approach for retirement that is as secure and fulfilling as possible. Get in touch if that sounds like a good plan.