Problems with Simple Financial Planning

monkey

My previous post demonstrated how a young guy named Rich got out of school, worked 40 years and saved enough to retire with an income equal to his final year salary from actually working.  The key assumptions I discussed were that he would need to save 21% of his income for all 40 years and get a modest salary increase every year.  What I did not discuss was the probability that he would be able to earn a steady 8% rate-of-return (ROR) on his 401k year in and year out.

 I should note that his discussion is for your entertainment and designed to get you thinking about the future.  Implementation of any concepts described should be reviewed with a professional financial planner beforehand.

 As any student of personal finance, you should readily ascertain, the actual ROR you earn may jump around considerably.  I’ve been an active investor for over thirty years and I have had years with double digit gains and years with double digit losses.  On balance, I am far ahead for having been in the market of stocks and bonds since the early ‘80s.

 The interesting question is: what happens after Rich retires if he is unable to sustain his desired ROR and, perish the thought; he actually loses money for a year or two in a row?  First regarding ROR, you will likely want to dial risk down once you retire.  This implies a lower expected ROR due to fewer equities and more fixed bonds and cash in your portfolio.  The 8% Rich shot for and achieved in pre-retirement may drop to say 5%.  A 5% expectation might assume 50% equities at a 6% ROR and 50% equities and cash at a 4% ROR.

 The second dynamic is the variability of the returns Rich earns over time.  Planners use Monte Carlo Simulation models to study this, but a simple example drives the point home.  I ran some numbers on Rich’s portfolio, which was $947,272 at retirement.  If the market were to drop by 30% in his second year of retirement and an additional 10% in his third year and he maintained his retirement income plan (final year salary increasing at 3% inflation each year), Rich would run out of retirement money from his 401k in less than thirty years.  He would still have a modest Social Security income but he wouldn’t be Rich any longer – he would be Poor.

 The only way to ensure this doesn’t happen is to stay in the market with a diversified portfolio of stocks and bonds, allocate among a number of different asset classes, save more when you can, and in retirement be prepared to cut out the extras in order to conserve your retirement money when your investments behave poorly.

 Stayed tuned … more to come.

 

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