By Raoul Rodríguez
“Do I have enough saved to retire?” is one of the more frequent questions I get as a certified financial planning professional. It is human nature to crave certainty, especially in an uncertain world, and coming up with a definitive “number” for retirement is an endeavor that has consumed many. Today you can find articles, books and even seminars on how to determine your unique amount. While the marketing phrase of “determining your number” is catchy, in real life the answer to how much you need to retire is neither easy to determine, nor is it definitive.
Many years ago, it was common to use a straight-line formula to help tell people how much they needed to have saved by the time they retired, effectively recommending a single target number. The target would be determined by taking current expenses, applying an inflation factor, and determining the cost of the current expenses in future dollars. Next, accounting for present savings, assuming a static average annual rate of return throughout the period, and calculating how much you needed to save over the following years to arrive at the number. The answer was a bold projection that almost never came true! Today most financial planning professionals have adjusted their methodology, moving from providing a number to providing a probability percentage.
Let us examine a few sets of assumptions: rates of return, economic factors, and life issues. As anyone that has invested in the market is aware, annual returns are all over the place. Sometimes they are good, sometimes they are not so good. It is not realistic to assume that a person will receive the same return year in and year out. As you might expect, the sequence of returns will have an important effect on the total return of a portfolio over a given holding period. Let us assume we have two sisters: each with US$10,000 to invest. The first sister earns a very respectable 10% in year one, two, and three. The second sister invests her US$10,000 in a more speculative fund and her returns over three years are as follows: negative 20%, positive 25%, and positive 25%. It is interesting to note that in both cases the average annual rate of return is 10%! You might think that they would end up with the same terminal value.
At the end of the investment period, the sister who invested in the more volatile fund ended with US$12,500, compared to the first investor who had US$13,310. The total rate of return of the first sister is 33.1% and the return for the second is 25%. That difference in significant and material to the success or failure of their respective plans. We know that the sequence of your returns over your entire lifespan has an important impact on your savings. In addition, negative returns at the beginning of retirement have an outsized effect on the portfolio, an issue that is compounded if you also need to draw down the portfolio in a down year to fund your expenses. This double whammy creates a bigger hole to dig out of and this variability of returns over time is known as sequence risk.
Another problem with the straight-line method is it does not account for the economic factors that can directly impact the future value of an investment. In addition to an assumed required rate of return, inflation and tax rates are two variables that do not remain static over time either. Many of us who have “been around the block” know that it is impossible to plan for all of life’s eventualities with any certainty: people get married, divorce, have kids, take care of grandkids, and/or aging parents, move to Mexico, become disabled, receive an inheritance, live beyond expectations, spend too much, save too little, need long-term care, and, eventually, pass away. All these life events, and importantly, their timing and duration, can have a profound impact on any projections that may have been previously prepared. The longer we peer into the future, the more likely that life will get in the way and derail our projections.
The variety and richness of our life experiences and goals, both what we plan for and what may come, can often be expressed in terms of an economic cost. How much you need to have saved at retirement is directly proportional to how much you assume you will spend going forward. Just like rates of return, there is significant variability in people’s annual expenses over time; the farther you are from retirement, the higher the variability. But even within a retirement time horizon, there is variability. In the first years, sometimes referred to as the “go-go years,” spending tends to stay close to pre-retirement levels as some expenses disappear, but we also start to take up activities we have would have liked to have undertaken, but for which we did not have the time nor the money to do: visiting kids and grandkids, traveling, staring a new hobby, etc. Next, come the “slow-go years.” In this phase, we are getting older, we are feeling our age more, we have checked off much on our bucket list, and we tend to prefer a less hectic pace. Spending in this time tends to be significantly lower than what we were spending prior to retirement. Finally come the “no-go years” when spending tends to pick up again, approaching or exceeding pre-retirement levels in real terms. The main driver of expenses here tends to be medical bills. Interestingly, because medical expenses are much lower in Mexico, this phenomenon might not be as pronounced as in the U.S.
If straight-line assumptions are not ideal given so many variables, how do we plan around the uncertainty of returns, changes in the economy, and the variability of expenses? Many financial planning professionals today will use a Monte Carlo Analysis which allows us to run thousands of trials over an assumed lifespan and randomize different rates of return and varying annual expenses. Trials will randomly assume some very bad years, for example at the beginning of retirement, to account for sequence risk. The output will be a probability percentage. In my practice, I am comfortable with probabilities between 85% and 95%. A percentage of 92% means that out of 1,000 randomized trials, in 920 there were enough assets to meet all stated goals-note: the 80 cases where investment assets were not sufficient. Anything below 85% makes me-and most clients-nervous. Anything over 95% might indicate that a client may be unnecessarily holding back in spending. Therefore, often this methodology has substituted the “number” for the “percentage!”
Even with a Monte Carlos Analysis, periodic updates are needed and your calculated percentage may go up or down over time: current spending and the cost of future goals must be reviewed. In addition, economic assumptions, such as inflation, expected rates of return, and tax rates, need to be adjusted. We can also stress-test the portfolio to account for black swan eventualities or other assumed events that can have an outsized impact on the success or failure of a given financial plan.
If you live in Mexico, you will need to take these projections with a grain of salt. The dollar to peso exchange rate, varying inflation levels, Mexican tax rates, for example, are not inputs that can be added to U.S. based programs but have a definite impact on your projections just the same. Generally, living in Mexico is less expensive in absolute terms and even more so when expressed in US dollars, often resulting in higher probability numbers for those that chose to live here. The reverse is true. If you move to the U.S., it is often the case that you will need higher savings in order to maintain a given lifestyle.
Given that so much of the future is unpredictable, is it worth planning at all? Studies have shown that those that engage the services of a financial planner have a much higher rate of success. By establishing savings goals prior to retirement, and spending goals in retirement, adjusting as life circumstances change and periodically running Monte Carlo Analysis, we can keep you pointed in the right direction. Planning, like life, is a path, not a destination.
