When you last did your projections for
retirement through the tools offered from your 401(k) plan or the book your
financial advisor put together, are you sure the assumptions that were made
were explained to you clearly? Or did
you challenge each assumption made within the financial plan to be certain that
the assumptions matched your level of risk tolerance and were reasonable for
where the next 25 to 40 years are headed within our economy. Making assumptions
is something we do every day in our lives. Essentially, as assumption is
nothing more than something taken for granted or accepted as true by making
educated guesses based upon prior data or experience. In other words, it is
belief without proof.
We recently saw the data that inflation hit a
40 year high at 9.1%. At that rate, the cost of everything you buy would double
over the next 8 years. This means that a car which costs you $45,000 today
would be $90,000 in 8 years. A pair of jeans that costs $100 would be
$200. Even a large coffee that cost you
$3 would be $6. While I don't think
inflation is going to hover at 9% over an extended period, the numbers could
clearly put us in a position where inflation hovers around the 4% mark over the
next 25 to 40 years versus the sub 3% rates we have seen over the past 25
years. This ONE small assumption could
be the costliest mistake you make in your financial plan and could make you
miss an early retirement date or even run out of money.
Here are three assumptions that you better
revisit and why YOUR FINANCIAL ADVISOR may have gotten it wrong!
Assumption- Most financial planning
software gives you or your financial advisor a chance to assume a certain
inflation rate. If the software only uses whole numbers (which most do), then
you have a problem with your financial plan already. The difference between using 3% and 4% is
astronomical when it comes to calculating your overall retirement numbers. To
give you perspective, from January 2012 to January 2022 inflation grew at a
total ten-year rate of 23.6% (2.36% per year). From January 2002 to January
2012, inflation grew at a total ten-year rate of 27.99% (average 2.8%). From
January 1992 to January 2012, inflation grew at a total twenty-year rate of
64.13 (average 3.21%). The reason I shared the data this way is that most of
the financial plans typically show a client a 3% whole number inflation rate
(recently I have seen plans that show 2.5%).
While it is true that inflation rate has been low historically, you
should consider that using a lower inflation rate within your plan will show an
analysis that you need less money in retirement. And the numbers vary by a lot!
If you make the mistake of using a low inflation rate of 2.5% or 3.0%, the odds
are your financial plan will be off by $500,000 to $1,500,000 and you will
probably RUN OUT OF MONEY! By using more aggressive assumptions, you will leave
yourself much less margin for error if in fact inflation stays north of 4.0%
over the next 25 to 40 years.
Of Return On Your Money Assumption
- Most of you who have put money in
your 401k's over the last decade have likely noticed that your increases have
strictly come from your extra contributions from you and your employer. Every financial plan will ask you to make a
data entry on the expected rate of return with your assets. You can choose to
tell the computer that you will earn 4%, 6%, 8%, etc. on your retirement
assets. Remember that with the simple rule of 72, you can generally tell how it
will take for your original principal to double. If you choose 10% as a rate of
return assumption, it will only take 7.2 years for your original money to
double. If you use 4% it will take a whopping 18 years for your money to double
in value. I see far too many financial plans done by firms showing clients be
able to earn 8% or 10% in the retirement section of their financial plans. This
is a huge mistake. By using something more conservative in the 5% or 6% range,
you will give yourself a more realistic view about how much you really need to
save for retirement. What happens if the markets (both bond and stock) happen
to move sideways like they did in the 70's over the next decade and you must
start withdrawing money from your retirement plans?
There are many other assumptions that can go wrong including health care assumptions and overall expense assumptions where mistakes can be made, but these are the big three that I would ask deeper questions about whether you do your own financial plan or hire a professional to do one for you. Knowing how to make conservative assumptions can give you much more margin for error as you develop your retirement plan over your lifetime. Avoid assumption mistake so the day you get on the doorstep of retirement and ring the doorbell you don't find out nobody is home!
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