Over the years, many have asked us, “How can we be sure of the assumptions used in retirement planning?” For example, a reader writes, “One of the big unknowns is the real expense during retirement. We can make an educated guess based on current living expenses, etc. However, surprises are likely to come and be disrupted. Medical expenses are a big surprise – after a certain age, insurance is also unavailable. While hospitalization and treatment are one part – getting home care is another big part of the age-related medical expenses. And there could be more such expenses. To what degree is our assumption of inflation-adjusted current expenses accurate for a 30-40-year horizon? Or is this the best we can do?”.
This is an extremely important question because it touches upon a common financial planning mistake. So, is retirement planning guesswork? The short answer is yes (naturally, the context needs to be explained). How can we be sure of the assumptions made? The short answer is that we cannot.
What is the objective of retirement planning? It is to ensure that a person can enjoy a lifestyle similar to or close to the lifestyle they are currently living. Many readers have the wrong impression about what “current lifestyle” means.
They assume that we plan for retirement with some assumptions at, say, age 35, and these assumptions are expected to hold until we retire 20 years later (for example), and if they do not hold, the retirement plan has failed because we guess wrong.
Our lifestyle changes from year to year. We went from feature phones to smartphones from one year to the next, from dial-up internet to fibre broadband, from cable TV to multiple OTT platforms, from two-wheelers to four-wheelers, and so on.
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A retirement plan must consider (as closely as possible) all lifestyle changes (both good and bad, necessary or unnecessary) that occur from year to year. The only way to do this is not to plan once and forget about it but to plan every year with new inputs and assumptions. That way, the “guess” is closer to reality.
I have reviewed my retirement plan each year since I first made it – late 2010 or early 2011. Over this time, the following has occurred:
- inflation has decreased. I used to insist on using 8% as the inflation estimate but today I find 6% reasonable (excluding lifestyle creep).
- Fixed-income returns have come down: Anything less than 8% was unthinkable. Today, we have learnt to live with 7% PPF returns.
- Equity returns have also come down, but only to those bothered to look. Back then, expectations were common at 15% or 18%. Today, the pragmatic investor will be happy with 10% to 12% returns (before tax!).
- My expenses have increased significantly due to lifestyle creep rather than inflation (of old expenses). New expenses are the enemy! Updating this is crucial. We cannot assume
- I have somehow managed to achieve financial independence despite these developments only because the rate at which I increase my investments is much higher than the return. See: Why increasing investments each year is crucial for financial freedom.
- Over the years, I have also improved my retirement plan by including de-risking schedules, income flooring and annuity laddering. See: Use this annuity ladder calculator to plan retirement with multiple pension streams.
We cannot afford to create a plan and forget all about it for even five years. The only solution to ensure the guess is not wrong is to update it frequently. Then, the fear goes away automatically if it is right or wrong. Two caveats, though.
(1) Our inflation estimate should align with how our actual expenses increase and not close to what the government declares. Lifestyle creep is the most dangerous aspect of retirement planning. Use this free personal Inflation Calculator to find the inflation rate of your expenses.
(2) Do not be in a hurry to reduce inflation estimates! It is okay to reduce return estimates, though! Retirement planning needs to be as foolproof as possible. So, expecting less (return) and more (inflation) than being disappointed is better.