Credit: Validate your assumptions. As a 25-year veteran of commercial nuclear power operations, I consider this one of the key concepts in operational success. Don’t assume a component is in its correct position – go check. This same validation principle can also be applied to one’s retirement planning, an activity that is often filled with assumptions. Of these many assumptions, two have a significant effect on your plan’s conclusions: the rate of your portfolio's return and your estimated life expectancy. Mis-estimating either or both of these could lead to shortfalls in one’s retirement, perhaps even past the point of recovery.
Portfolio Performance
Past performance is no guarantee of future results. Never before has this precautionary statement been more relevant. On the bond side of one’s portfolio, intermediate to long-term interest rates have been declining for 30 years. Starting in the low teens in the early 1980s, we have seen the 10-year Treasury dip as low as 1.35% this year. An interesting side effect of declining interest rates is that it provides a boost to the total return of bond funds, a commonly used instrument in many portfolios. The longer maturity funds have benefited the most from this effect. (For more, see: How to Solve the Retirement Equation.)
While interest rates may not have finally bottomed out, it is safe to say they likely won’t go much lower. For this reason, historical returns may not be the best proxy for planning assumptions. Rather, I suggest looking at the a fund’s SEC yield, or 30-day yield. This is a required parameter which attempts to estimate the near-term forward returns of the fund based on current price and interest being collected. In other words, the SEC yield may be closer to what an investor will actually experience. And in a declining rate environment, this SEC yield is typically lower than the historical, which makes some sense. The interest payments keep getting smaller over time.
On the stock side of one’s portfolio, a forward look is a bit more challenging for any number of reasons. That said, some intelligent people have developed estimation models based on market fundamentals that provide a sense as to whether higher or lower than average returns can be expected.
John Bogle, the Vanguard titan, has an interesting method that can readily be found online. Based on his method, Bogle has been quoted as saying that his 10-year forward estimate for stock returns could be as low as 4% per year. This is much lower than the often used 8-10% per year, which is valid only for much longer time horizons (roughly 30 years). This difference in expected returns is largely attributable to a lower dividend yield coupled with a historically high PE ratio. As with any investment, the price one pays largely determines the overall return and at present, stocks are expensive.
To finish this rate-of-return portion of the planning process, blend the bond yield and stock projection using your preferred asset allocation ratio (50/50, 70/30, etc.) and plug that combined forward estimate into your retirement planning calculation. The resultant amount of required savings may surprise you. (For more, see: 5 Questions to Answer Before Retiring.)
Life Expectancy
Physical health and wellbeing have long been a priority to me. Naturally, both longevity and quality of life are my goals. From the life expectancy statistics available on the Social Security Administration’s website (www.ssa.gov), it is clear that not only are people living longer (80 years and beyond), but the odds of living to age 65 have increased dramatically over the years. Couple this trend with ever improving medical treatments for cancer and heart disease, and we may well see life expectancies push towards 100 in the very near future. For someone intent on retiring at 60, this could mean funding 40 years of retirement from one’s savings and Social Security. With this possibility in mind, how might your retirement plan be affected?
For an estimate of my potential life expectancy, I used a website called Livingto100.com but there are other websites you can use. It can take about five minutes to complete the no-cost evaluation. Based on my current health, lifestyle and family history, I can apparently expect to live to 91 (or at least not be surprised if I do). While there is no sure means to predict one’s life span, I can assure you that this has had an effect on my life planning. (For some fascinating insights into lifestyle factors that improve longevity, read “The Blue Zones Solution” by Don Buettner. Great book!)
Crux of the Matter
So this is the crux of the matter: the future is yet to happen and therefore, it is uncertain. We have also seen how the past might provide a misleading glimpse of the future. In these times of rapid change, this reality may have never been more true. After all, we once believed that housing prices would never drop in unison, until they did. For the sake of your financial future (and peace of mind), validate your critical retirement assumptions with forward-looking measures. See the road ahead through your windshield, not the rearview mirror. Your future self will no doubt be grateful. (For more, see: What to Do to Prepare for Retirement.)
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
