Will you run out of money in retirement?

Image by antstang699431 via Vecteezy

By Andrew Kobylski and Caroline Whittaker Huggins
Posted on April 30, 2021

You just left a meeting with your financial adviser, and your nest egg is looking bulletproof, with a projected worth of over $1 million at age 95.

But wait a second: Are you sure about that? If your financial projections look too good to be true, they might well be, for a variety of reasons.

When the pandemic hit in March 2020, the stock market crumbled, and many people saw their investment portfolios drop. Fortunately, the markets eventually recovered, but the sudden drop caused many people to review their investments.

While reviewing a new client’s portfolio at that time, we learned that his previous adviser projected his net worth as double our estimate by age 70. Naturally, the client was confused by the different scenarios.

We discovered that the underlying growth assumptions the former adviser used were far too optimistic, giving the client an unrealistic view of his financial future.

Be safe; plan for the worst

It’s easy for any adviser to make a financial plan look unbreakable when using unrealistic assumptions. The true value of a financial plan comes from testing its resistance under difficult conditions.

To do this, financial advisers typically conduct a “stress test.” The test typically examines how a financial plan will fare during a future unexpected event, such as a recession or major geopolitical event, and allows you to adjust accordingly.

For example, if you are near retirement and your portfolio is heavily weighted in stocks, an unexpected recession may send it plummeting by double digits. Although there may be no recession in sight, stress testing would allow you to adjust your portfolio in advance to safeguard it from potential future harm.

It’s a good idea to consider asking your financial adviser to conduct this test. Here are four areas to discuss to ensure your plan will hold up:

What’s the implied growth rate?

Most financial advisers build a conservative growth rate into their projections — 5% annual growth is a common rate. While changing the growth by even a couple of percentage points may seem irrelevant, it can monumentally alter the trajectory of your projection.

Take this scenario: A 45-year-old has $1 million in investments and saves $20,000 annually. If we omit taxes and assume a realistic 5% annual rate of return, his portfolio will grow to around $4.3 million by age 70.

However, if this person’s adviser assumes a higher return, the projections show a scenario that is likely unrealistic. For example, at a 9% annual growth rate, his investments at age 70 would be valued at $10.3 million.

Our research shows that the average investor loses 4% of their annual returns from simple mistakes stemming from investment selection, fee management and emotional trading. Not accounting for this principle in your plan’s growth rate assumptions may inflate your projected future assets.

Our advice: Lean toward conservative growth assumptions to ensure your financial plan can withstand the unpredictability of future market returns.

Account for inflation

It’s not surprising $100,000 had greater spending power in 1950 than it does today. This can be seen in something as simple as the price of milk, which in 1950 was 83 cents. Today, the average price per gallon is around $3.60.

As we know, some expenses can have higher cost-of-living adjustments than others, such as healthcare or even education costs. Due to the ever-growing cost of living, accurately depicting inflation is necessary when developing your financial projections. Otherwise, your projections may misrepresent your future reality.

Our advice: Since the cost of living will rise in the future, make sure you account for this growth in your financial projections. For most general living expenses, we typically like to assume an inflation rate of 2.5%.

Check accuracy of your spending

During a planning session, a client reported she was spending around $120,000 annually, or about $10,000 per month. But when asked to map her annual expenses for one year, she realized she was spending closer to $140,000.

We discovered that the additional $20,000 primarily came from home improvement costs, roughly $500 a month on takeout/Amazon orders, and other miscellaneous one-off expenses that tend to go overlooked.

This difference is significant. Compounded over time, this spending rate will affect her income in retirement. Rather than lasting through age 95, her assets would be depleted at around age 80. Using this information, we were able to get her back on track toward meeting her financial goals.

While taking the time to monitor your annual expenses is important, even with a budget in place, unaccounted-for expenses are bound to appear. The stress test can account for additional expenses that are typically overlooked, such as home upgrades, car repairs or any other unanticipated one-off costs.

Our advice: It’s a good idea to partially overstate your annual spending level to account for future, unknown costs. While everyone’s spending situation is different, grossing up annual expenses anywhere from 5% to 10% allows the plan to account for future unknown costs.

Other uncertainties

Whether it’s a forced early retirement or a bear market, stress testing your financial plan will help account for other uncertainties in the future. It will not only test the plan’s strength, but also your individual financial flexibility.

Knowing a plan can withstand a 30% market dip provides peace of mind. A test can also simulate the financial impact of taking a dream vacation or providing gifts to your favorite charity, giving you more freedom to spend your money in retirement.

Navigating from your expected financial plan to these “Plan B” scenarios can display the robustness of your financial plan against unforeseeable risks.

Our advice: While it’s fine to look at the most likely financial scenario, consider a worst-case scenario, too. People often make their best financial decisions when they understand the potential consequences.

There is no doubt that future events will have an impact on our financial future. By using realistic assumptions and mapping out all relevant scenarios, you can help make certain your plan can still deliver on your goals should these difficult conditions occur.