Many retirees think their financial plans are solid, anchored by facts and figures. But what if those figures are based on overly optimistic or unrealistic assumptions? The fine print in your financial projections might have a bigger impact on your future than you’d expect.
Behind every plan is a set of assumptions about market performance, spending patterns, lifespan, and more. These assumptions aren’t always consistent across advisors or tools, leading to plans that often differ dramatically. Understanding these assumptions is critical to avoid costly missteps and to make informed decisions about your retirement.
This article will walk you through key areas where hidden assumptions in retirement planning can have a significant impact and provide the tools needed to ask the right questions and take control of your financial future.
Why Assumptions Matter in Financial Planning
Financial plans can’t predict the future; they’re built on models that rely on assumptions to simulate possible outcomes. These assumptions include market returns, life expectancy, and even your spending habits. The problem? Different advisors or financial software often use varying assumptions, which can drastically alter the outcome.
For instance, one advisor might assume a higher average annual return for the market, producing an optimistic projection for your retirement. Another may use more conservative estimates, showing a lower probability of success. While both plans could technically be accurate based on their data, they tell very different stories.
The assumptions underlying your plan determine its apparent “success.” The more you understand those assumptions, the better equipped you’ll be to make confident decisions about your retirement.
Monte Carlo Simulations: A Helpful But Imperfect Tool
Many financial advisors use Monte Carlo simulations to estimate the likelihood of your financial plan working under different scenarios. This tool runs thousands of simulations, factoring in variables like market performance, inflation, and spending to calculate a “success rate.” For example, an 85% success rate indicates that 85% of the tested scenarios resulted in you not running out of money during retirement.
But Monte Carlo simulations are only as good as their inputs. If the assumptions are flawed or overly rosy, the results may paint an unrealistic picture of financial security. Worse, plans are often judged solely on these success rates.
It’s also important to understand what “success” means in these models. Often, a result is deemed a success if there’s just $1 left at the end of your plan. Does this truly reflect the comfortable retirement you’re envisioning? Understanding the limitations of Monte Carlo simulations can keep you from being lulled into a false sense of security.
Pitfall to Remember:
Monte Carlo success rates don’t account for the “magnitude of failure.” A 15% failure rate might mean running out of money two years before you pass away, or it could mean running out ten years early. Both are technically failures, but the impact on your quality of life could differ drastically.
The Danger of “Plan Shopping”
“Plan shopping” happens when individuals compare plans from different advisors based solely on metrics like success rates. For example, if one advisor presents a plan with a 95% success rate and another shows a 65% success rate, it’s tempting to pick the higher number. But this approach often ignores the hidden assumptions behind those results.
Was the higher success rate achieved by excluding long-term care costs? Did the plan assume lower spending in later years? Did the plan include an unrealistic assumed rate of return? Higher success rates can sometimes indicate unrealistic assumptions that aren’t aligned with your actual retirement lifestyle.
The most sensible financial plan isn’t always the one with the highest success rate. The better plan is one based on realistic, thoughtful assumptions that accurately reflect your circumstances and goals.
The Hidden Risks in Financial Projections
Even a small tweak in financial assumptions can dramatically change the picture a financial plan paints. For example:
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- Return Estimates: A plan that assumes an 8.5% annual return will look far rosier than one that assumes a 7% return. But is the higher estimate realistic for your portfolio?
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- Spending Patterns: Some plans assume spending will naturally decrease as you age. While this might be true for certain expenses, costs like healthcare and long-term care often rise significantly in later years.
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- Long-Term Care Costs: Excluding long-term care expenses can make a plan look much better on paper but fails to account for likely future costs. Planning for these expenses upfront can save you from financial surprises down the road.
Stress-testing your retirement plan against more conservative assumptions helps uncover hidden risks. Does your plan account for market volatility? How does it handle unexpected healthcare expenses? These are crucial questions to explore.
Key Questions to Ask Your Financial Advisor
When reviewing your retirement plan with an advisor, don’t shy away from asking tough questions. Here are a few to guide the conversation:
“What return assumptions are being used?”
“Are the expected returns conservative, aggressive, or somewhere in between? What evidence backs up those assumptions?”
“How does this plan account for market volatility?”
“Does the plan address years when markets underperform, or is it based on a straight-line projection of consistent returns?”
“Have long-term care costs been included?” If not, ask for an estimate of these expenses to see how they impact your financial outlook.
“What is the assumed lifespan in this plan?” Plans that assume you’ll live to 85 differ dramatically from those that plan for a lifespan of 95 or longer.
“Does this plan adjust for spending changes over time?” Ask how the plan accounts for fluctuations in expenses, such as reduced travel spending or increased healthcare costs.
By asking these questions, you can better understand the assumptions underlying your plan and ensure they align with your goals.
Build a Retirement Plan You Can Trust
The best retirement plan doesn’t sugarcoat the numbers or rely on overly optimistic projections. It takes a realistic approach, accounting for risks and uncertainties while aligning with your vision for retirement.
Before committing to a plan, make sure you fully understand its assumptions. By asking the right questions and staying informed, you empower yourself to make decisions that lead to financial security and peace of mind. Looking for expert guidance? Schedule a free 15-minute consultation with a financial advisor at Mclean Asset Management. You and your advisor will work together to build a plan based on solid, realistic assumptions to set you up for long-term success. Schedule your consultation here
Want to learn more? Listen to Ep. 169 of the Retire With Style Podcast.
