As the firstborn son of an architect, I grew up in the early 1970s listening to my Dad’s near constant refrain of “measure twice, cut once” on every home repair project in need of my conscripted labor. I didn’t know it then, but it was my first introduction to making deliberate data driven decisions. Angles got measured in degrees, lengths measured in feet and inches, and the price of everything was cheaper by the dozen. It wasn’t until I got to Jr. High and was introduced to the metric system that I discovered not everyone measured things the same way as my Dad. Even at an early age, I sensed that miscommunication over standards for how things got measured just might turn out to be a huge problem. Yikes, talk about an understatement.
These days there are scores of commercial financial planning software applications available for download. Some are free and some cost thousands for professional subscribers to gain access to all the bells and whistles. While nearly all can get the job done when placed in the hands of a skilled practitioner, every single application we’ve encountered comes pre-loaded loaded with a standard set of asset class assumptions based on historical volatility and rates of return. Woe to the investor that blindly accepts the implicit financial assumption the next 30 years are going to be just like the last 30 years. Or even the last 60 or 70 years. Possible? Maybe. Likely? Not so much.
Consider the default data behind one of the more popular financial planning applications…one we happen to think is quite good. The default return assumptions used to build cases draw heavily on historical market data from 1952-2020. In this world, core cash generates forward looking returns of 1.04%, government bonds generate forward looking returns of 4.29%, and large cap equities generate forward looking returns of 9.99%. I don’t know about you, but in 2021 those baseline numbers seem more than a touch optimistic. We’re certainly not alone in our thinking as forward looking return expectations employed by large swaths of asset managers and economists have been marching to a steady drumbeat of downward revisions for the past several years.
So, what rate of return numbers should you employ when considering your own financial plan or checking the scenarios presented by your advisor? Rather than looking back at simple historical returns, train yourself to think more like an insurance or pension fund actuary and ask, “are these rates of return assumptions something I’d be willing to guaranty if I knew I personally would need to make up any shortfall?” Unlike an insurance company however, you don’t have the backstop of external shareholders to kick in funds should your return assumptions prove to be overly optimistic. Fortunately, most financial planning applications allow rate of return assumptions to be tweaked to something other than historical data. Make sure you know what the forward-looking inputs should be and calibrate those inputs to an appropriate time horizon. Need resources to find this data on your own? The Congressional Budget Office along with most of the large banks, brokerage houses, and mutual fund companies (think firms like J.P. Morgan, Vanguard, or Blackrock) publish free research promoting the views of their analysts. For instance, I searched Google for “2021 market return assumptions” and got more than 92 million results in 0.66 seconds. Equally important, make sure you consider how much of those returns you’ll actually get to keep in the event federal and state tax rates creep higher.
By now it’s undoubtedly been pounded into your head that distributions in retirement will need to grow over time to protect your standard of living from the corrosive effects of inflation. Unless you are one of the fortunate few that have a defined benefit pension with a guaranteed cost of living adjustment (COLA) rider, this is a big deal.
The longer your life expectancy, the more personal expenditures will grow with inflation. Even at modest rates of inflation, the future value of expenses 10, 15, or 20 years down the road can be eye popping. If you are simply using the most recent consumer price index (CPI) number in the planning process, it’s probably not enough.
In the first place, your long-term assumptions need to look ahead to incorporate an inflation estimate that makes sense within the broader context of your asset class returns. For example, don’t assume bond returns will average 3% and inflation will be 6%. Negative real returns certainly might happen over one or two years, but they are statistically unlikely to persist over the long term. Instead, use a baseline inflation number that is closer to the rate of return number you use for cash and less than the return number you expect to earn on bonds.
Next, don’t assume all your living expenses will inflate at identical rates. For things like food, clothing, property taxes, and general household expenses, the CPI might be a reasonable estimate. On the other hand, medical visits, prescription drugs, college tuition assistance for the grand kids, and long-term care expenses will almost certainly grow at a rate ahead of CPI. Other expenses, like your mortgage, won’t change at all. Make certain your financial plan segregates these expenses and assigns an inflation premium to make sure you have sufficient funds to cover these items down the road.
Investors that manage to skirt these predictable measurement miscues may not be assured of building a financial tower that reaches the heavens. You will, however, stand a better chance than most to ensure your towering financial plan isn’t toppled by a measurement problem that started back when you were laying the foundation.
Michael Reid, CFA is a Managing Director and Partner at Exchange Capital Management, a fee-only, fiduciary financial planning firm. The opinions expressed in this article are his own.