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Optimal Finance Daily - Financial Independence and Money Advice
3424: [Part 1] Dealing with Uncertainty in Retirement Calculations by Darrow Kirkpatrick of Can I Retire Yet
00:11:42
Darrow Kirkpatrick exposes how even modest shifts in retirement planning inputs, like inflation, returns, or lifespan, can produce drastically different financial outcomes
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This is optimal Finance Daily Dealing with Uncertainty in retirement calculations part one by Daro Kirkpatrick of caniretireyet.com remember the game of telephone? Players whisper a secret message down the line from one to the next. When the message reaches the end of the line, it's repeated aloud to the group and without fail, it's been mangled beyond recognition. Retirement planning can be like that. Seemingly small differences in input can compound into gigantic differences in output. It's a serious problem both in retirement and planning for it. In many cases, the range of input to your retirement equation creates an uncertainty interval so wide that that it makes predicting the future absurd. In this post, we look at a simple scenario that demonstrates the problem. I'll show how much the uncertainty in key variables such as growth rate, inflation rate, and lifespan can impact your ending net worth. Then, after reviewing what retirement models are and are not good for, we'll discuss solutions. Understanding Uncertainty in Retirement Calculations to better understand uncertainty in retirement calculations, I tested a simple retirement scenario. A couple retiring at age 60 with initial retirement savings of $500,000 and annual expenses of $40,000. They'll start taking the average Social Security benefit at age 65, and they'll pay an overall effective tax rate in retirement of 5%. Let's see what happens to them under different conditions. Factors that Dominate Retirement Projections I wrote a while back on the three unknowns that dominate retirement calculations. Let's start with those three variables and add a few others altogether. We'll consider the best and worst cases for five input parameters to the retirement equation. Number one Investment returns. Given low interest rates and high stock market valuations, most experts are predicting reduced investment returns going forward. But within that dim outlook, there's plenty of variation. You could reasonably assume US large cap stocks to return 5% before inflation and 10 year investment grade corporate bonds to return 2.5% in a 5050 portfolio. That would be a 3.8% real rate of return. Let's call that our best case. Alan Roth has drawn from William Bernstein's rational expectations and from Robert Arnott to come up with a 1.5% real rate of return for a 5050 portfolio. Let's call that our worst case. Number two, inflation. While it's trendy now to fret about inflation, and until the past few months, it's been relatively tame for decades. If you look at the historical record for inflation, you can spot double digit inflation in the past, but it's never lasted long. For our simulation, let's assume the best case for inflation is 2%, about 1% below the long term average. And let's assume the worst case is 4%, 1% above that average. Sure, inflation could spike, but. But as you'll shortly see, even at 1% above the average, it does plenty of damage. Number three, life expectancy. Nobody knows how long they'll live, but we each have family history to draw on. Also, we know that modern healthcare is steadily improving. For our purposes here, let's use some mainstream numbers from the Social Security Administration. A man Reaching age 65 today can expect to live on average until age 84.3. And about 1 out of every 465 year olds today will live past age 90. And 1 out of 10 will live past age 95. So let's call age 84 our best case, financially speaking, and age 95 our worst case. The longer you live, the more chance you'll run out of money. So that's a worse case for financial planning. Social Security. Most of us will rely on Social Security to some extent, but we all know it's threatened. The average benefit right now is about $1,335 per person for retired workers. But the Social Security Administration says that could change because by 2034, the payroll taxes collected will be enough to pay only about 79 cents for each dollar of scheduled benefits. So let's say the best case is that our hypothetical couple will receive their $1,335 a month times 12, times 2, or about $32,000 annually in benefits. And let's say the worst case is that they'll only receive about 75% of that, or about $24,000 annually. Expenses. Budgets are Personal. But for purposes of our simulation, let's say our frugal couple needs to get by on about $40,000 a year. But living expenses aren't static. They'll vary with life events and with the economy. Personally, we spend more than this model couple. And still we've seen unsettling fluctuations in our retirement budget already. Some of it has been discretionary fun, but healthcare expenses have been particularly alarming. We've already seen 25% deviations from our retirement budget in a single year. So while our couple's best case expenses may be $40,000 a year, let's say their worst case is another 25%, or $50,000 a year. A realistic range of uncertainty. So that's the input for our scenario. Nothing too far fetched here. The best cases don't sound wildly optimistic. The worst cases don't sound particularly dire. Each number is entirely feasible within a range supported by the data and the experts. But what happens when we put these numbers all together in one simulation? The results are surprising. Let's start with the best case scenario and proceed gradually to the worst. Best case scenario. The best case scenario involves low inflation, high investment returns, full Social Security, no changes in living expenses, and shorter lifespan. Under those conditions, our couple reaches the end of their lives at 84 and leaves a nice $477,000 for their beneficiaries. If they're fortunate enough to live longer, their net worth keeps growing. At age 95, it would be $587,000. Note these numbers and those that follow are adjusted to today's dollars for ease of comparison and worst case scenario. Now let's introduce our first worst case scenario. What if inflation runs at 4%? We crunch the numbers again. Now the net worth at age 95 is about $568,000. In today's dollars, the impact of inflation is muted because most of our couple's cash flow is inflation adjusted in some form. What next? How about if real estate returns are reduced to 1.5%? Well, now their ending net worth at age 95 is only 143,000. Then what if they're only able to collect 75% of their Social Security? Now their net worth drops into negative territory at age 95 to negative 167,000, implying they ran out of money years before. Now what if their expenses increased by a real 25%? On top of all the other bad news? This really hurts. Their net worth now plummets to negative $647,000 at age 95, implying an even earlier end to their retirement funds to have stayed afloat at their current lifestyle to age 95, they'd need to have raised an extra 647,000. Reviewing each year in this financial scenario, with all of these worst case factors compounded, we see that at age 75 should just 15 years after retiring, our unfortunate couple is broke. To be continued. You just listened to part one of the post titled Dealing with Uncertainty in Retirement Calculations by Daro Kirkpatrick of caniretireyet.com.
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Management made Simple While I do think considering worst case scenarios is important when it comes to financial planning, this article made me think of a phenomenon often referred to as the one more year syndrome. It's when someone meets their financial independence target, but then doesn't quit their job because they decided to move the goal post out of fear or because they're overanalyzing their plan out of fear. I once met a guy at an event called Camp Mustache who had quadruple what he needed to retire. I'm talking multiple millions of dollars and he was looking for reassurance from the group that he could pull the trigger. He had safety net upon safety net and lived a super frugal lifestyle and it was clear to all of us that he had way more than what he needed to retire. And yet he was still scared. This is a very common thing that happens in the fire community. Many of us have spent years or even decades carefully saving and investing, so it can be difficult to shift your mentality once you've won the game. This is so common, in fact, that that one of the most well attended breakout sessions at the Economy Conference was called One More Year When Can I Pull the Trigger? And it was facilitated by Mr. Money Mustache. Well, that should do it for today. Have a happy rest of your day and a great start to your weekend and I'll see you on the Saturday show tomorrow where we'll finish up this post and where your optimal life awaits.