Your Retirement Planning Assumptions Are Not Conservative Enough

Your Retirement Planning Assumptions Are Not Conservative Enough

We can’t see into the future, but we can make wise decisions now.

There are a lot of planning assumptions that enter into how we tackle retirement planning. Now that the trauma from the Great Recession is beginning to subside, we may need to look at how we are planning, saving, and investing for our retirement.

Are we doing enough? Can we expect more of the same returns based on the market’s historical average? Some experts think our retirement planning assumptions are not conservative enough.

What Are Some Planning Assumptions We Use?

Financial planning is built on assumptions. No one knows what will happen a year from now, and it is almost impossible to understand what the financial landscape will look like when you are ready to retire in 20 or 30 years. So financial planners and retirement experts typically use historical averages for the assumptions that we all have grown accustom to using to build our plans.

Some of the most popular financial planning assumptions revolve around how well your investments will perform, how the economy will respond in the long-term, and other very macro factors.

Here are some of the typical planning factors:

  • Investments will historically return 8% annually.
  • Inflation will run about 3% annually.
  • 4% annual withdrawal of your nest egg is optimal.
  • Social Security will be intact in some form.
  • We will live to the average age in the actuary tables.

But the real question remains: Are these retirement planning assumptions still valid? Are they unreachable now? Do we need to make these assumptions more conservative for the future?

Can We Still Expect To Earn 8% Annually?

Dave Ramsey has taken a lot of heat throughout the personal finance world recently for expecting a 12% annual rate of return. But, historically, the S&P 500 Index and stock market have a long-term rate of return of 8% annually.

While there have been several bear markets, there have also been years where the market has returned much more than 8%. For example, the stock market rose 13.4% last year, and it has risen over 11% since January of 2013, despite the recent rough patch this month. So should 8% continue to be the mark on the wall for our planning purposes? It all depends on how optimistic you are on the U.S. economy, but you must consider decades and not just weeks or months.

Maybe our planning assumptions with respect to the stock market are right in line with historic averages. Or, maybe our current thoughts are clouded with recent events in the market and its rise.

How Long Will We Live?

Most financial planners and the computer programs they use to build financial plans use government actuary tables to determine how long we are expected to live. According to statistics complied by the Security Administration, a 65-year-old man can expect to live until he is 84, on average. A 65-year-old woman is expected to live until she is 86.

This is all fine and dandy until you blow past that age and outlive your retirement nest egg. Then what are you supposed to do? Have you seen the commercial currently running on television where people are asked to place a dot on a graph for the oldest person they know? The average may be 84 and 86, but 49% of Americans are above average. Over the course of the past few years, Americans have increased their life expectancy by 1 year. How long we think we will live may very well be one retirement planning assumption we should look at more conservatively going forward.

How Much Can We Withdraw?

For a long time, financial experts have recommended a 3% to 4% withdrawal rate every year in retirement in order to avoid outliving your retirement nest egg. The retirement planning and simulations that calculate potential outcomes use the 8% annual rate of return on investments you should theoretically earn in retirement and a 4% safe withdrawal rate to ensure that you will not run out of money.

Sophisticated computer simulations are used to determine the probability of running out of money with market fluctuations included. For example, using historical stock market returns from 1900 until present, you would most likely have a 95% probability of outliving your money. That is where the 4% withdrawal rate comes from and it has now become the standard in the industry. But how do the probabilities change if you withdrew less? If you are more conservative in your planning, you can have more confidence leading into retirement.

What Will Inflation Be Like In The Future?

The Consumer Price Index (CPI) is a statistic that is updated monthly providing a snapshot of the country’s current rate of inflation. The index tracks the changes in the prices for a select basket of goods and services, but it is of note that the index does not factor food and energy prices into its calculations. For the past ten years, the CPI has maintained an average of 2.47% which is inline with inflation’s long-term average.

Todd Tresidder from Financial Mentor wrote the book How Much Money Do I need To Retire?, and he thinks we are likely to see higher inflation in the years to come. “While nobody has a crystal ball, it would likely be prudent and realistic to give the U.S. a higher inflation assumption than 3%. How high you want to go depends on how conservative you want your calculations to be and the level of security you require in retirement,” said Tresidder.

Inflation has often been a volatile metric. In the 1970s and 1980s it has been between 5% and 10%. There have also been periods in history where inflation has spiked to almost 20% annually during times of war or oil crisises. “Assuming 3% inflation is little more than a guest based on a fairly narrow interpretation of history,” said Tressider.

Because of the government’s monetary policy of printing money and quantitative easing, many other financial experts agree with Tresidder. Typically, the printing of more money from the U.S. government is a recipe for increased inflation in the future.

If inflation rises above the historic rate of about 3%, it will continue to erode your investments earnings. It will not mean much if your investments are earning an 8% rate of return every year but the cost of living rises at a faster than normal rate. If your investments earned 8% and inflation was 10% annually, for example, you’d be losing money and buying power despite your investment account balance rising.

Will Social Security Be There For Younger Generations?

If you are in your 20s or 30s, you may be wise to NOT count on Social Security benefits when you finally reach retirement age. Will there be some type of benefit available? Maybe. Will there be a lot less benefits than our parents received? Probably.

According to the Medicare Trustees who run the government program, Medicare’s hospital insurance fund is set to begin to running out of money in 2024. In 2033, the Social Security Administration estimates that it will pay out just 75% of scheduled benefits to retirees.

We’ve painted a pretty grim picture. It all comes down to how you view the market and how likely you think the stock market and economy will perform over the very long horizon. I’m not talking about how the stock market will average even in the next 10 years. If you are in your 20s and 30s now, you have over 30 years until you reach the standard retirement age in America.

Will the market continue to average 8% returns over the next 30 years like it has done in the past 100? Only time will tell what the market and economy will hold in the very long term. The more conservative you make your assumptions the more probable your financial plan will help to ensure you have enough money to retire comfortably and not outlive it.

What do you think? Are these retirement planning assumptions still good? Which ones would you recommend that we look to change?




Last Edited: August 5, 2013 @ 7:03 am
About Hank Coleman

Hank Coleman is a fan of everything personal finance. He's the creator of the popular site Money Q&A, as well as other financial sites. Hank is currently studying to become a CFP. His freelance writing work can be seen across a variety of top-notch publications in finance and investing.

Comments

  1. Nice post Hank.  A couple of comments.  First even if the stock market does average 8% many investors have a more balanced portfolio that contains lower risk holding such as bonds.  In exchange for reducing risk returns on bonds will generally be lower.  I suggest that using the average return on the S&P 500 is bogus both because as you say it might be too optimistic and also because few investors (hopefully) have portfolios that 100% equity.
    Second while the “4% rule” is a great estimating tool it is only a rule of thumb.  There is no substitute for a detailed financial plan.
    Third I would caution younger workers to not count on Social Security or even a pension. Maybe I’m being too cautious but planning for one’s financial independence via your own savings and investments is a far safer route in my opinion.