Head in the Sand Planning
By Henry K. (Bud) Hebeler
There are a number of major problems with forecasting that the financial industry and the government trivialize to present an optimistic view of the future. We’ll show you some solutions to get more realism in your personal projections.
Problem: The finance industry is the largest sector in the total of all sectors that make up the stock and bond markets. To cover the financial industry’s hundreds of billions of overhead and profit, brokers, analysts, and financial institutions must make their products look attractive and encourage people to invest and reinvest in new products thereby getting additional transaction fees. In order to gain favor, they often obscure or even hide the amount they take from the transactions by referring to historical market index returns which do not include their fees and costs. You would be extremely fortunate if you were able to achieve the returns of a mix of pure indexes, especially when the mix is determined by melding whatever allocation of security indexes did the best over some opportunistic period of history.
Solution: When making return projections, subtract the costs of mutual funds, brokers, and/or agents from historical returns of a mix of stocks and bonds because the historical index returns don’t reflect these costs. For example, your research may find that the historical index returns for your portfolio averaged 7.0%. The average mutual fund has costs of about 1.5%, so the net return would be only 5.5% for the average investor.
Problem: Those who are in retirement take another licking. The financial industry acknowledges dollar-cost-averaging as a way of boosting returns—which is a reality for those who make regular deposits to the same stock fund over a long period of time. (On the average, a program of regular deposits enhances the gains because the investor buys fewer shares when their price is high and more shares when the price is low.) Conversely, retirees regularly take out money from their investments and thereby experience REVERSE dollar cost averaging. As a consequence, retirees’ returns are likely to be significantly lower than an index even if the index is adjusted downward to reflect the fees and costs of the financial industry.
Solution: For the years in retirement subtract about 1% from returns in addition to subtracting the costs of mutual funds brokers, and/or agents.
Problem: There will be many retirement surprises that take significant cash. These might include family things such as elderly parents who run out of retirement money or a daughter who has several children and then decides to get a divorce. Or there may well be uninsured medical or dental problems, unforeseen replacement of costly items such as a roof or automobile, or a plunging stock market that abruptly changes your view of your future financial success.
Solution: Include known replacement costs of expensive items as discrete entries in your planning program, but you need reserves for unknowns as well, perhaps 10% of investments for fairly wealthy people or even 100% of investments for those with little savings. Reserves should not be counted as an investment when trying to project how much you can spend each year till death.
Problem: Plans that assume retirees will be able to live comfortably on something like 70% to 80% of working income ignore the realities of ever increasing medical and dental costs and the methods that people, business, insurance, and the government have to cope with such costs.
Solution: People who are within twenty years of retirement should prepare a detailed retirement budget derived from current budgets, but use much larger medical and dental costs, perhaps 1.5 times today’s insurance and service quotes if these costs continue to run at twice normal inflation.
Problem: The country is awash in record debt at all levels: international, national, state, business, and personal. Further, both Social Security and Medicare need substantially more funds to meet promised benefits as do public and private pension plans. We cannot continue to ignore what these will do to the future economy.
Solution: The government has few options except to reduce benefits, increase taxes and print more money, that is, let inflation go to higher levels. This cheapens promised future benefits and makes current debts look relatively smaller. Plan on higher tax rates when in retirement and base plans on a significant jump in inflation, perhaps 4.5% instead of the common 3% assumption.
Problem: Finally, there is the modern concept of determining a retirement spending level that, after adjustment for inflation each year, will exhaust your investments over the period of years that you might live in retirement. Even the supposedly sophisticated Monte Carlo analyses favored by most professional planners use exhaustion analysis as the basis of each iteration. There are two very large fundamental flaws here. The first is the pretence that you can predict the outcome with certain confidence, and the second is that people do not spend the same inflation-adjusted amount of money each year.
Solution: The best thing to do is to is to avoid exhaustion analyses (See the Dynamic program from www.analyzenow.com.) or at least don’t plan on exhausting investments until well over age 100. Even then, understand that the planning admonition that the future may be different from the past is real and that success probabilities are meaningless.
Conclusion: It’s a good idea to rethink the results you get from almost any kind of a planning process whether it comes from a magazine, financial web site, self generated spreadsheet, commercial planning program, or even from an expensive personal analyst. Failure to account for financial realities and adversities is hiding your head in the sand—which is just what the government and most of the financial industry would like you to do. Saving little and spending lots now makes the current economy vibrant and profits soar--but little savings won’t help your long-range future.