Wednesday, November 11, 2015

Why Constantly Updating Retirement Projections is Vital

New retirement projections should consistently be created to reflect changing circumstances. While short-term fluctuations in retirement plan outcomes should be anticipated and not cause an over-reaction, long-term implications should receive attention and be addressed.

Base Scenario

Consider a 65-year old retiree who would like to withdraw the inflation-adjusted equivalent of $20,000 of after-tax dollars per year from his investment account until age 90. This individual’s nest egg consists of a $500,000 IRA, and his financial plan estimates an average annual investment return of 6%, an effective tax rate of 18%, and an inflation rate of 3%. According to these assumptions, the individual’s financial plan indicates a high probability of success. A Monte Carlo analysis, which accounts for varying sequences of returns (because a flat 6% return isn’t achieved every year but rather achieved on average over time), calculates a success rate of 85%.

Impact of the 2000’s

Now, consider this same individual with one adjustment – that it is the year 2000 and we are about to enter what is now looked at as the “Lost Decade.” During the next 10 years, the S&P 500 averaged an annual return of less than 1%. Let’s assume the investor had a diversified portfolio, which would have generated superior returns to a 100% large cap stock portfolio, and achieved an average annual return of 2% during the decade. Of course, the individual would have still been withdrawing the inflation-adjusted equivalent of $20,000 of after-tax dollars per year during this time period.

At the end of the decade and when the investor is 75 years of age, his nest egg would have been depleted to $301,784. By contrast, if the investor had achieved the anticipated annual return of 6%, his nest egg actually would have increased in value over this time period, ending the decade at a value of $521,185. Unfortunately, the unexpected lower rate of return has severally reduced the success rate of the individual’s retirement plan to an unacceptable 39%.

Note that in this situation, the investor didn’t do anything wrong. With the benefit of retrospect, we can see that an extended period of essentially no growth in the stock market was unavoidable. This illustrates the importance of paying more attention to variables that we can impact (such as spending) and less attention to factors that are out of our control (such as short-term market returns).

Benefit of Plan Updates

Without adjustments, this individual now has a high probability of outliving his money – the ultimate failure of retirement planning. For this reason, updates need to be made to the individual’s financial plan so these issues can be identified and addressed. An analysis of the investor’s new circumstance at age 75 can discover that if annual portfolio withdrawals are reduced to an inflation-adjusted equivalent of $17,700 of after-tax dollars, the financial plan’s success rate bounces back up to 85%. While spending less than the investor’s goal is not ideal, it is certainly better than running out of money.

It is also worth noting that the 6% long-term investment return anticipated by the investor’s financial plan at age 65 may still very well come to fruition, even after enduring a 10-year period with such a low growth rate. Just as it was possible for returns to be unusually low for the “Lost Decade,” it is equally possible that returns will be above average for an extended period of time in the future. In fact, this scenario has actually played out as the S&P 500 is already up over 100% since 2010. Consequently, it is possible that our hypothetical investor would have only needed to reduce spending for a short period of time and that the quick market recovery would have enabled him to return to his previous withdrawal goals relatively quickly. Of course, frequently retirement plan updates would identify when the individual would be able to return to his more comfortable level of spending.

Frequent Updates are Preferable

Lastly, it is important to note that even a quick market recovery can’t save an investment plan if there is no money left in the portfolio to experience the bounce. For this reason, it would be better if our hypothetical investor actually reduced spending during the period of slow market growth as opposed to after the extended period of lackluster returns. This is exactly why I’d recommend updating your financial plan at least annually – so issues can be identified quickly and adjustments can be made efficiently and when they have the most impact.

Unanticipated factors that affect retirement planning occur frequently. These variables range from market declines, to higher inflation rates, to changes in the tax structure, to surprise healthcare expenses, to new rules involving Social Security. Frequently updating your financial plan will help identify some of these issues – which are frequently out of our control – and allow us to address shortcomings by focusing on factors that we can adjust.


Holborn Assets said...

Agree with your point "Unanticipated factors that affect retirement planning occur frequently." Great post Lon.


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