The majority of individuals spend surprisingly little time planning for
retirement. In fact, 30% of individuals in one survey indicated that they would
prefer to visit the dentist’s office than plan for retirement. Making matters
worse, much of the planning they do accomplish is often based on overly
optimistic assumptions. “We find that many individuals are using simplistic and
flawed assumptions when estimating the adequacy of their retirement savings”
says Peter Passalacqua, a Certified Financial Planner with Frontier Financial
Planning in Somerville, New Jersey. “For instance, many people will apply an
assumed rate of return to their retirement nest egg to determine available
income. If the resulting income level seems adequate, the individual is
satisfied.” Passalacqua explains. “Regardless of the interest rate being applied,
this thinking ignores two critical factors which influence the adequacy of a
retiree’s income. One is inflation, and the other is investment risk”.
The effect of inflation is easily understood with a simple spreadsheet analysis.
Assume on the first day of retirement, a retiree invested a $100,000 nest egg at
a guaranteed fixed interest rate of 5%. Assume also that the resulting $5000 per
year, when combined with Social Security and pension income, is just enough to
cover this individual’s living expenses in year 1 of retirement. How long will
the money last? Without considering inflation, the money could be expected to
last forever, since the investor is only spending interest income. Increasing
the $5000 annual living expense by 4% per year, however, results in a much
different picture. Under this scenario, the investment account will be depleted
in 20 years.
Adding risk to the forecast can really muddy the water. Let’s say that, after
considering the effects of inflation, our retiree decides that he needs a higher
rate of return on his investments, and is therefore willing to take on some
investment risk. As a result, the investor puts his money in an investment
account with 60% stocks, 25% bonds, and 15% cash. Based on historical
performance of similar investments, he believes he will receive an average rate
of return on this portfolio of 9%. The problem is that the actual rate of return
will be subject to significant fluctuations from year to year. As a result, the
simple projections we used to determine the longevity of the guaranteed
portfolio will not provide the same level of certainty once investment risk is
introduced.
“Portfolio risk has a huge and underappreciated impact on retirement planning”
says Passalacqua. “You may expect your portfolio to average, say, 9% over 25
years, but the timing of good years and bad years can dramatically influence
your investment results. Although we feel comfortable projecting average long
term returns based on historical performance, no one can predict which years
will be good and which will be bad. This is the biggest challenge a planner must
overcome in determining the adequacy of an individual’s retirement savings.”
Many financial planning firms uses statistical modeling tools such as Monte
Carlo simulations to estimate how long investment accounts can be expected to
last given various withdrawal rates and inflation assumptions. “With tools such
as Monte Carlo, we can provide our clients with statistical probabilities that
they will achieve a particular goal, given their savings rates and investment
choices” Passalacqua explains. “Some of our clients are surprised to find that
the retirement assets they had projected to provide retirement income for life
may have only a 60% chance of lasting until they are 85 years old. Many others
are surprised to find that their ultra-conservative portfolios of bonds and CD’s
have less chance of surviving retirement than a more aggressive portfolio which
includes some stocks and growth investments”.
Many baby boomers are undoubtedly looking forward with great anticipation to
their upcoming retirement. These future retirees would be well advised to double
check their retirement planning assumptions to make sure they have adequately
accounted for inflation and investment risk. It may take a little effort, but
the stakes are high. It may be that a little extra last minute savings effort is
needed to ensure that the golden years will truly be golden. Then again, the
local Wal Mart store is always looking for part time help.
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