Assumptions aren't always a laughing matter, and that's certainly true when it comes to retirement planning, where "hope for the best, plan for the worst" is a reasonable motto. Incorrect retirement-planning assumptions are particularly problematic because, by the time a retiree or pre-retiree realises their plan is in trouble, they 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.
Assumption 1: That Stock and Bond Market Returns Will Positive
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 fair, stocks' long-term gains have been pretty robust. The S&P 500 generated annualised 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 similar. 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 annualised basis.
The reason for stocks' weakness 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.
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 meagre – roughly 2% or 3% for most high-quality bond funds. That translates into a barely positive real inflation-adjusted return.
Assumption 2: That Inflation Will Be Low or Nonexistent
In a related vein, currently benign inflation figures – CPI is currently just 0.3% – may make it tempting to ignore, or at least downplay, the role of inflation in your retirement planning. Like robust return assumptions, modest inflation assumptions can help put a happy face on a retirement plan.
But should inflation be greater than you anticipated in the years leading up to and during your retirement, you will need to have set aside more money and 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 customise 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 be greater in the future than it is today also supports the idea of investing in inflation-hedges in your retirement portfolio to help preserve purchasing power once you begin spending your retirement assets. That means diversifying into stocks, which historically have had a better shot of outgaining inflation than any other asset class, commodities, inflation-linked bonds, precious-metals equities, and real estate.
Assumption 3: That You'll Be Able to Work Past Age 65
Never mind how you feel about working longer: the financial merits are irrefutable. Continued portfolio contributions and delayed pension withdrawals can all greatly enhance a retirement portfolio's sustainability.
Given those considerations, as well as longer life expectancy 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 disconnection between pre-retirees' plans to delay retirement and whether they actually do.
What to Do Instead: While working longer can aide your retirement plan, it's a mistake to assume that you will 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 the very least, give your post-age-65 income projections a trim 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.
Assumption 4: That You'll Receive an Inheritance
A recent study revealed more parents intend to leave their children an inheritance than the children expect to receive one. But that doesn't mean there's not the potential for some adult children to receive less than they expected to.
Increasing life expectancy, combined with long-term care needs and rising long-term care costs, means that even parents who intend for their children to inherit assets from them may not be able to. Alternatively, the parents may not be inclined to give at all, even if they have the money.
Adult children who expect an inheritance that doesn't materialise may be inclined to overspend and undersave during their peak earning years. And by the time their parents pass away and don't leave them a windfall – or leave them much less than they expected – it could be too late to make up for the shortfall.
What to Do Instead: Don't rely on unknown unknowns. If you are incorporating an expected inheritance into your retirement plan, it is wise to begin discussing the topic as soon as possible. Alternatively, if you do not want or need an inheritance but suspect that your parents are forgoing their own consumption to give you one, now is the time to have that conversation too.
This article orginally appeared on Morningstar.com. It has been edited for a UK audience.
