At some point in everyone’s life they begin to think seriously about retirement. We’ve
written several articles on various aspects of retirement (past articles are on our website
– see link below) but have yet to discuss some of the more technical factors that can
impact the quality of your retirement planning.
Numerous websites have retirement calculators to help individuals determine whether
they will have enough money in their senior years. Some of our clients who have used
some of these tools have expressed a lack of confidence in the results, due to the high
variability of results from one calculator to the next. Much of the variability is likely due
to differences in the assumptions each tool uses. A small difference in tax rates, the
assumed inflation rate or expected rate of return for investments can yield significantly
different results.
Perhaps some of you may have read an article or two discussing a “rule of thumb”
regarding four percent withdrawal rates. Basically the rule says that at the beginning of
retirement you can take out four percent of your total portfolio balance (including both
principle and earnings) in the first year, the first year amount adjusted by inflation the
following year, and so on. According to the rule, following this approach will result in
your funds lasting 20 to 30 years through all types of economic cycles. How long your
funds last depends on the percentage mix of stocks and bonds in your portfolio. Using
this approach to plan for a retirement years down the road still requires making
assumptions about inflation, taxes and rates of return. So while this “rule of thumb”
approach seems easy to apply, it can still require some complex forecasting.
And what if four percent of your savings won’t meet your retirement needs? How do you
know what to do to fix the problem? You could save more, work longer, plan to spend
less in retirement or be more aggressive with your portfolio.
A number of financial planning software programs in the marketplace analyze retirement
by creating detailed cash flow projections until life expectancy. The resulting projections
represents one scenario based on one set of assumptions. While most planners are
careful to be conservative in the assumptions used, it is difficult to predict how a
projection will hold up in the myriad of possible future scenarios. This type of retirement
planning is limited since it only gives you a black and white answer to whether or not you
can afford to retire.
More sophisticated financial software programs are now available to planners. Instead
of doing just detailed cash flow analysis, some software programs on the market now
offer goal-based planning tied into full cash flow analysis at retirement. It provides
planning for multiple financial goals and the ability to add, remove or reprioritize goals
easily. These programs also offer an extensive offering of assumptions that can be
changed so that multiple scenarios can be quickly analyzed with little effort. Rather than
answering a cold hard “Yes” or “No” to the proverbial retirement question, these
programs are able to work with you to show what it takes to get to “yes”. It can even
give you the confidence that you can afford to spend a bit more!
As an example of how such a software program might work, let’s suppose that besides
achieving a comfortable retirement, you have the additional following goals, in order of
priority:
1. Take a trip every year in retirement
2. Make a home improvement every three years
3. Buy a second home in South Carolina
4. Help fund your grandchildren’s education
An initial projection might indicate that you will not likely be able to afford three of your
goals. After discussion with your financial planner you decide that it would not be a big
problem to work another couple years (to save more in your 401k and increase your
pension payment), take a smaller trip than you originally planned every other year, and
only make home improvements every four years. A new software projection now
indicates that you have a 100% probability that you will meet ALL of your goals! Now
that’s what we call a workable plan!
What’s even more important is that these advanced software programs provide the
ability to do what is called Monte Carlo analysis. Monte Carlo analysis shows the
probability that your retirement plan will be successful using statistical data. It does this
by running thousands of iterations of your plan while varying the investment returns year
by year. Another useful feature that some programs have is the ability to do stress
testing, which re-runs plan scenarios using variable year-by-year returns, to see the
effects certain market scenarios have on the results.
The bottom line is that whatever approach you take in your retirement planning, it needs
to be sophisticated enough to determine a high probability of a successful retirement
and should also allow you to easily evaluate a variety of retirement scenarios. After all,
isn’t retirement all about having financial peace of mind with every decision you need to
make?
David C. Patterson, CFP® and Erin Preston, CFP® are the owners of Patterson
Advisors, LLC, a fee-for-service-only financial advisory firm. Patterson Advisors, LLC is
a Registered Investment Advisor, registered with the State of Michigan, helping clients in
Waterford, Clarkston and Royal Oak, Michigan as well as other Oakland County,
Michigan communities . Visit www.pattersonadvisorsllc.com for more information or call
248-674-2108.
Published in the Oakland Insider, August, 2008
A Quality Retirement Plan Depends on Many Factors
By David Patterson and Erin Preston (formerly Patterson)