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Faulty Assumptions

Richard Quinn

I SAW A GRAPH recently generated by some retirement-planning software. It showed the investor enjoying substantial portfolio growth over the course of his 30-year retirement. Forget running out of money. This particular software program says the guy’ll be a 90-year-old multimillionaire.

My curiosity piqued, I used the same software to run numbers for my finances. I ran optimistic and pessimistic assumptions. I entered my monthly expenses and my fixed income. I tried to run out of money, or at least show a decline, in my total assets. No luck. I just kept getting wealthier over the next 20 years—assuming I have 20 more years.

Even when inflation hits my buying power and I’m compelled to pull more from cash, there’s no negative impact on my assets’ growth. I also projected an extra withdrawal for a new car. Why not? The software still showed me getting richer.

This experiment led me to question the software’s validity, or at least the validity of the assumptions used. This software assumed a 4% withdrawal rate, 4% inflation and an 8% annual rate of return.

Many people put a lot of faith in planning software, betting their financial life on assumptions, projections and past performance. The assumptions are usually theirs, but are they accurate? Do they reflect the reality of how they’ll live in retirement? 

For example, all these planning programs factor in inflation. Is your personal inflation rate the same as the Consumer Price Index? Probably not. By adjusting your buying, you can lower your true inflation rate. I could, for instance, lower my thermostat during winter to 55 degrees. Such an action, however, may also reduce my retirement’s fun factor.

Or you can just game the system by fudging your inflation assumption. If you use a 4% inflation rate, does your plan fail? Tweak it to 3.5%, and you might find instant success. This seems risky to me.

If you’re assuming an 8% average annual investment return, does your portfolio hold enough stocks to notch that sort of growth? Do you plan on changing to more conservative investments as you age? And what about that warning that “past performance is no guarantee of future results”?

One person I spoke to is convinced retirement-income needs are overstated, and this is partly fueled by faulty software projections. The projected shortfalls create a demand for investment products and lead folks to over-save, my acquaintance contends. I don’t know about that. But I do know people are making critical long-term bets using assumptions that may prove far too optimistic or conservative.

Thirty years is the typical retirement planning assumption. But U.S. life expectancy for a 55-year-old man is 24 years. At 60, it’s 20 years and, at 65, it’s only 17 years. For women, life expectancy is some three years longer. How many people are likely to be retired for 30 years? It’s not a bad goal. Just understand it might not be realized.

I’ve talked to some people who assume they’ll tap home equity, or maybe sell their home at some point in retirement, to cover their retirement’s costs. But what’s the backup plan if they change their mind?

Are people honest with their expected expenses? Detailed planning, with folks often trying to account for every dollar over many decades, is impossible. My advice: Keep it simple, and use your current expenses plus any obvious changes, such as paying off a mortgage if that’s scheduled to occur.

Research shows that the average retired household’s consumption falls between 0.75% and 0.8% each year. Retirees in good health and with more wealth dont adjust their spending as sharply as those with poorer health and less money.

Are retirees adjusting their spending because they’re compelled to or does their spending naturally decline? I never planned to spend less and we haven’t, but we certainly spend differently. I just overheard a discussion between Connie and our construction guru son about kitchen cabinets and a new floor. What can they be up to?

Planning for retirement is no easy task, especially when that planning involves income that can be variable, expenses that we can’t fully control and assumptions that are little more than guesses. I see software as one tool, but not the sole driver of decisions. Step back and conduct a sanity check on your plan. Consider having a neutral pair of eyes review your assumptions.

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