Incorrect--and usually too rosy--retirement-planning assumptions are particularly problematic because, by the time a retiree or pre-retiree realizes her plan is in trouble, she may have few ways to correct it; spending less or working longer may be the only viable options.
What follows are some common--and dangerous--assumptions that individuals make when planning for retirement, as well as some steps they can take to avoid them.
Dangerous Assumption 1: That Stock and Bond Market Returns Will Be Rosy
Most retirement calculators ask you to estimate what your portfolio will return over your holding period. It may be tempting to give those numbers an upward nudge to help avoid hard choices like deferring retirement or spending less, but think twice.
To be sure, stocks' long-term gains have been pretty robust. The S&P 500 generated annualized returns of about 10% in the 100-year period from 1915 through the end of last year, and returns over the past 20 years have been in that same ballpark. But there have been certain stretches in market history when returns have been much less than that; in the decade ended in 2009, for example--the so-called "lost decade"--the S&P 500 actually lost money on an annualized basis.
The reason for stocks' weak showing during that period is that they were pricey in 2000, at the outset of the period. Stock prices aren't in Armageddon territory now, but nor are they cheap. The Shiller P/E ratio, which adjusts for cyclical factors, is currently at 27, versus a long-term mean of 17. Morningstar's price/fair value for the companies in its coverage universe is a not-as-scary 1.04, meaning that the typical company is 4% overpriced relative to our analysts' estimate of intrinsic value. But that slight overvaluation surely isn't a bullish signal, either.
What to Do Instead: Those valuation metrics suggest that prudent investors should ratchet down their market-return projections somewhat just to be safe. Morningstar equity strategist Matt Coffina has said that long-term real equity returns in the 4.5% to 6% range are realistic. Vanguard founder Jack Bogle's forecast for real equity returns is in that same ballpark.
Investors will want to be even more conservative when it comes to forecasting returns from their bond portfolios. Starting yields have historically been a good predictor of what bonds might earn over the next decade, and right now they're pretty meager--roughly 2% or 3% for most high-quality bond funds. That translates into a barely positive real (inflation-adjusted) return.
Dangerous Assumption 2: That Inflation Will Be Mild or Nonexistent
Like robust return assumptions, modest inflation assumptions can help put a happy face on a retirement plan. But should inflation run hotter than you anticipated in the years leading up to and during your retirement, you'll need to have set aside more money and/or invested more aggressively in order to preserve your purchasing power when you begin spending from your portfolio.
What to Do Instead: Rather than assuming that inflation will stay good and low in the years leading up to and during retirement, conservative investors should use longer-term inflation numbers to help guide their planning decisions; 3% is a reasonable starting point. And to the extent that they can, investors should customize their inflation forecasts based on their actual consumption baskets. For example, food costs are often a bigger slice of many retirees' expenditures than they are for the general population, while housing costs may be a lower component of retirees' total outlay, especially if they own their own homes.
The possibility that inflation could run higher than it is today also argues for laying in hedges in your retirement portfolio to help preserve purchasing power once you begin spending your retirement assets. That means stocks, which historically have had a better shot of outgaining inflation than any other asset class, as well as Treasury Inflation-Protected Securities and I-Bonds, commodities, precious-metals equities, and real estate.
Dangerous Assumption 3: That You'll Be Able to Work Past Age 65
Continued portfolio contributions, delayed withdrawals, and delayed Social Security filing can all greatly enhance a retirement portfolio's sustainability. Given those considerations, as well as the ebbing away of pensions, increasing longevity, and the fact that the financial crisis did a number on many pre-retirees' portfolios, it should come as no surprise that older adults are pushing back their planned retirement dates.
With that in mind, there appears to be a disconnect between pre-retirees' plans to delay retirement and whether they actually do. The variance owes to health considerations (the worker's, his or her spouse's, or parents'), unemployment, or untenable physical demands of the job, among other factors.
What to Do Instead: While working longer can deliver a three-fer for your retirement plan--as outlined above--it's a mistake to assume that you'll be able to do so. If you've run the numbers and it looks like you'll fall short, you can plan to work longer while also pursuing other measures, such as increasing your savings rate and scaling back your planned in-retirement spending. At a minimum, give your post-age-65 income projections a haircut to allow for the possibility that you may not be able to--or may choose not to--earn as high an income in your later years as you did in your peak earnings years.
