When it comes to retirement planning, the assumptions you use are like the foundation of a house—get them wrong, and everything built on top can start to wobble. It’s not the most glamorous part of the planning process, but your return assumptions, inflation estimates, and spending expectations quietly shape your retirement path. And whether you realize it or not, those assumptions can dramatically change the outcome of your plan.
Let’s break it down.
Why Financial Assumptions Matter
Every retirement plan relies on assumptions about the future. These variables drive the plan output; specifically, how much you can safely withdraw, how your savings will grow, and how to manage inflation or unexpected costs. Using realistic numbers within your plan is crucial since overly optimistic or inaccurate assumptions can lead to potential financial instability.
For example, underestimating inflation can diminish purchasing power over time, overestimating investment returns might lead to unsustainable spending, and misjudging how long you’ll live could result in running out of money too soon. Aligning your assumptions with reality helps prevent such pitfalls and paints a more accurate picture of your financial future.
Tools to Handle Uncertainty: Monte Carlo Simulations and Stress Testing
No financial plan can predict the future with absolute certainty, but there are methods to help you evaluate your plan as you prepare for the unknown. Two of the most valuable are Monte Carlo simulations and stress testing.
The Monte Carlo simulation is one of the most popular tools for testing a retirement plan. It works by analyzing thousands of scenarios to estimate the likelihood of your plan’s success. A key function is to evaluate how your portfolio might perform under varying market conditions. If a Monte Carlo simulation shows a 90% probability of success, your plan is reasonably robust. A plan with a 50% probability, however, signals a need for adjustments to reduce risk. But here’s the catch—your inputs drive your outputs. If your return assumptions are too rosy, the simulation may show a high success rate, even if that’s not remotely likely in today’s market environment. On the other hand, if you plug in overly conservative numbers, you might think you’re hopeless when you’re actually in great shape.
Stress testing looks deeper at potential “worst-case” scenarios and how your plan success rate changes when your assumptions are adjusted for extremes. For example, it analyzes how your plan performance changes if markets perform poorly, inflation soars, or healthcare costs rise unexpectedly. This process examines whether your financial plan can endure difficult or unexpected circumstances while still supporting your long-term goals.
Using these tools is not about aiming for a perfect number. Instead, it’s about understanding your range of outcomes and thinking through how you’d respond if things go better or worse than expected. Running scenarios and stress testing your output helps you spotlight vulnerabilities and make smarter decisions about spending, investments, or withdrawal rates, aiming to eliminate unpleasant surprises down the road.
It’s Not Just About the Math
Good planning isn’t just numbers and charts. It’s about making sure your financial decisions align with your life. That’s where nuance comes in. We’ve seen overly optimistic clients assume high returns to justify higher spending. And we’ve also seen the opposite—people with more than enough money hesitant to spend and living like they’ll be eating canned soup in the basement for the next 30 years. Neither extreme is ideal.
A thoughtful plan helps you understand where you are today, what levers you can pull, and what trade-offs you might face down the road to keep you on track. The point is to create a plan that reflects the numbers and your real life—not just an abstract success rate on a chart.
Why Regular Updates Are Key
It is important to keep in mind that your plan is a living, breathing document. It’s not something you set once and forget about. That’s because the assumptions used to create the plan – like future market returns or inflation—aren’t set in stone. The real world shifts constantly, and your plan needs to be flexible enough to shift with it.
A retirement strategy created five or ten years ago may no longer reflect your current goals, financial circumstances, or market conditions. For instance:
- Market Changes: If markets outperform your expectations, you might be able to enjoy more spending.
- Life Events: Healthcare expenses, family support, or home repairs could require significant financial resources.
- Evolving Priorities: Your interests and aspirations can shift as circumstances change, requiring updates to your financial strategy.
Retirement planning is an ongoing, adaptive process based on thoughtful assumptions, reliable tools, and flexible strategies. It can be helpful to work with a financial advisor to review and update your retirement plan. Not only does this help to keep your assumptions relevant and realistic, it also provides an objective opinion about your plan and possible adjustments to consider.
Need a Second Opinion?
We believe financial planning is more than just math—it’s about helping you make confident decisions with your money that are grounded in reality. That’s where our sister firm, McLean Asset Management comes in. If you’re ready to stop guessing and start planning, they’d love to help.
Want to learn more? Listen to Ep. 170 of the Retire With Style Podcast.
