Three Key Assumptions To Make in Financial Planning - Rodgers & Associates
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Three Key Assumptions To Make in Financial Planning

When projecting your success for retirement the assump­tions you use can help ensure your success or could derail the outcome. Before you get giddy about your success make sure you under­stand and are comfortable with these 3 key assump­tions under­lying your plan.

-The first key assumption is which rate of return you use for the growth of your invest­ments. Histor­i­cally, a balanced portfolio with 4% in cash, 35% in bonds and 61% in a diver­sified stock portfolio would yield an 8.87% return*. But looking forward this investment rate may need to be reduced due to the tailwinds of a 30 year bull market in bonds as well as changes in corre­lation between various asset classes. Harold Evensky, CFP®, a noted financial planner and consultant to PIEtech, assumes a 7.05%* forward looking investment rate of return for this same balanced portfolio.

-The second key assumption to make is on the rate of inflation. Histor­i­cally from 1970 thru 2014 inflation comes in at a whopping 4.1%*. However, if you base future inflation on the Federal Reserves’ forecasted projec­tions you could use an inflation rate of 2.5%.  You may also want to consider the nature of your expenses. Will the cost of healthcare increase more or less than for the average retiree? Are you frugal or do you like to keep up with current trends with new cars and high end travel?

-The third and perhaps the most misun­der­stood and least talked about assumption is the standard deviation used for investment returns. Typically higher investment rates of return indicate a higher standard deviation. The higher the standard deviation, the more volatile the portfolio returns are expected to be. Volatility can often lead to a lower proba­bility of success as defined by Monte Carlo simula­tions. This is especially true for long time horizons and for portfolios more heavily weighted in stocks. Histor­i­cally the balanced portfolio illus­trated above has yielded a standard deviation of 10.44%*. Looking forward, Evensky uses a forecast of a 13.25%* standard deviation.

When comparing results between retirement projec­tions make sure you under­stand the assump­tions of each plan. By using conser­v­ative assump­tions your numbers will look lower but you should improve the odds of achieving your goals. Aggressive assump­tions would show greater growth but could lead to pie in the sky expec­ta­tions and, ultimately, failure. Start with conser­v­ative assump­tions and fine tune as necessary to improve your outcome. Financial planning, like life, needs monitoring. Tweaks and adjust­ments along the way can help you stay on course.

* The above rates of return, standard devia­tions and inflation rates are based on the research of Harold Evensky, CFP®, a consultant to PIEtech (MoneyGuidePro). MoneyGuidePro is one of the software packages Rodgers & Associates uses in our planning.