Technology brings convenience to many industries, and it’s no different in retirement planning. Nowadays, there are all kinds of projections, calculators and simulators that people can use to build their own retirement plans. And why not? Artificial intelligence and robo-advisers can seemingly do anything and everything.
But it can be risky and naïve to rely heavily on any of these “high-tech” routes.
That’s because numerous assumptions go into the number-crunching behind the scenes. Sometimes, the information is oversimplified, or people planning for retirement can input numbers without sufficient research, which can lead to incorrect conclusions and unfortunate financial outcomes that bring to mind the saying from the early days of computing: “Garbage in, garbage out.”
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Making the right assumptions
It is not a sound financial strategy for the long term to be overly optimistic or overly pessimistic about inflation, market returns, tax rates, life expectancy, volatility, etc., and to plug those numbers in yourself. Historical averages and current conditions must be weighed carefully and done so, not with algorithms as the main guide, but with an experienced adviser who knows and considers the ebbs and flows and can help you make more astute and safer assumptions so you don’t end up over-living or under-living your retirement.
However, the financial industry will often try to tell people there is a certain “retirement number.” There is no magic number. Because a quality integrated retirement plan has a number of parts that need to work together, it is important to have a guide outside your situation who knows how those parts fit together. Make sure, with the right advice, you are making the right assumptions around inflation, your income, investing, protection, tax, retirement spending and legacy plan. Don’t go in blindly and set yourself up to either overspend/give or underspend/give.
Here are some assumptions to be careful or cautious with, especially when working with AI-driven or AI-assisted financial platforms or tools. Any one of these assumptions can have a massive negative impact on your retirement plan.
Inflation
Let’s say someone has a retirement lifestyle that they think will require $100,000 a year today. They use a calculator and predict 2.5% average inflation per year as their guide, projecting it over a 25-year retirement. That $100,000 turns into $185,000 they will need in year 25. If the inflation assumption changes from 2.5% to 3.5%, that future lifestyle 25 years from now would require about $236,000 instead of $185,000, which is nearly 28% higher at that point in time. Each year beyond the first year requires more money, so you’re planning for 25 years of a cumulative and growing greater need.
How much will your retirement savings be worth years from now? Inflation affects the amount of savings you need and also the investment return you need — therefore, it also affects the level of risk you must take to get it. While Social Security benefits are loosely adjusted for inflation every year (and so are Medicare premiums and possible surcharges), it is essential to create an income plan that anticipates inflation over many years while allowing adjustments for inflation increases that may affect your short-term budget.
Look at your income sources to see how they respond to inflation. Many people have a pension income that doesn’t get a cost-of-living adjustment. Further, many married couples have pensions that will be reduced for surviving spouses, but that’s a different topic altogether.
An experienced financial adviser can help you determine a reasonable long-term rate of inflation, in part by reviewing inflation over past decades and looking at current trends.
Market growth
Let’s say someone has $1 million in surplus wealth, which they are not planning on spending in the near future or perhaps ever. Let’s assume a 6% compound annual growth rate. Over 25 years, the future value would be about $4.3 million. If 7% will be the average return, it becomes nearly $5.4 million. If I go with 5%, it is about $3.4 million.
These are massive differences with just a small change in the assumption. If you get inflation wrong or if you are unreasonable with assumptions on expected market growth, you can mislead yourself into thinking you are OK. Or you can mislead yourself into under-living in retirement, being so conservative that you are not deploying your resources to live and give the way you really could during your lifetime.
The stock market’s growth in recent times has been remarkable, but to assume the average annual return is going to continue as it has since 2008 is dangerous. There is usually a reversion to the mean — we just don’t know why, how, when or how long it takes. The main point is you need to have some realism and sobriety about it and, importantly, the difference between assumed market returns and inflation should be reasonable.
Taxes
Nobody knows exactly where tax rates will go, but you have to stress-test the sensitivity of your retirement plan with higher tax rates. You need to have a withdrawal plan that mitigates tax exposure while knowing that not all assets are taxed the same. Look at the history of government debt and tax rates (we have more debt as a percentage of GDP than any other time in history). When debt has been high, tax rates have gone higher. Today, the highest tax bracket is 37%, and the lowest is 10%. In 1946, when the debt was at similar levels, the highest tax bracket was 91%, and the lowest bracket was 20%.
Where is the government debt level going from its current 123% of GDP level? And for the wealthy folks (the top 1%, 10%, 25%, or 50% of people), what do you think the political forces want to do to your tax rates? This is not just about assumptions but also about taking proactive action. There are actions that can be taken to better position yourself for what may be ahead.
Life expectancy
As it relates to life expectancy, there is a fair chance for many to make it well into their 90s. Let’s say we have a couple in their early 60s. For them, there’s about a 40% chance that at least one of them will make it into their 90s. So, you need to make sure you have answers to navigate numerous economic and market cycles, given that retirement could end up being 30 years or more. You wouldn’t want to get that one wrong. Nobody wants to outlive their money.
Retirement spending
This is where people should be realistic with their assumptions. They need to “peel back the onion” and look at more than their average monthly spending according to bank statements from the past several months. They must take into account both the expected and the unexpected big expenses that come along from time to time — from repairs to health issues to helping out a family member — in addition to the trips and luxuries they’re planning for. These need to be added to the annual normal lifestyle. It’s also important to consider how strongly you desire to leave a legacy and, if so, make sure there are assets set aside for that purpose.
Volatility
A last note on volatility. Volatility can be crushing. In other words, when you are building wealth and adding money regularly, volatility can actually be helpful for a while. In retirement, it can be the opposite and become harmful. The key is to have some money that is not so volatile to use during volatile times. So, you need to determine if you want to test your retirement with greater or lesser volatility and think about distribution order.
Conclusion: The human touch
Having the experienced perspective of a financial adviser is crucial. Advisers can help ensure that the assumptions made in retirement planning are sound and reasonable, and based on how you think about money. They can help you, so you don’t set yourself up to over-live or under-live in retirement.
A good adviser will take a stress test of your plans, and then make some adjustments to increase confidence. It is not just a one-time effort, as most clients tend to change over time, and as they change, their financial needs do as well.
Top-down (“back of the napkin”) and bottom-up (detailed cash flow model) approaches are both informative. In other words, a simplistic model and a complex model should arrive at a similar conclusion. When they do, you know you’re probably on to something.
One final word of caution: Every simulation or scenario is just that. It is most assuredly 100% wrong after one year. Wealth usage and wealth preservation are very, very different from wealth building. It’s why having a guide or a financial adviser helping you think through your situation both strategically and tactically on at least an annual basis can be so beneficial.
Dan Dunkin contributed to this article.
The appearances in Kiplinger were obtained through a PR program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way.
The information contained herein is for educational purposes only. It is not intended to provide, and should not be relied on for, any tax, legal or investment advice. You are advised to seek the advice of a qualified professional prior to making any decision based on any specific information contained herein. The specific tax consequences of any investment or strategy will depend on your specific tax situation.
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