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, the surprises are likely to come and disrupt. Medical expenses are a big surprise – post a certain age, insurance is also not available. 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”.
“The point is, 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?”. So effectively the reader wants to know, “Is retirement planning guesswork? How can we be sure of the assumptions used?”.
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 be we 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 is able to 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.
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Our lifestyle changes from year to year. We went from feature phone to smartphone from one year to the next; from dial-up internet to fibre broadband; from cable TV to multiple OTT platforms; from two-wheeler to four-wheeler and so on.
A retirement plan must take into account (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 to not plan once and forget about it but to plan every year with new inputs and new assumptions. That way, the “guess” is closer to reality.
I have reviewed my retirement plan each year since the first time I made it – later 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 then. Today we have learnt to live with 7% PPF returns.
- Equity returns have also come down but only to those who have bothered to look. Back then 15% or18% expectations were common. Today, the pragmatic investor will be happy with 10% to 12% returns (before tax!). See: Ten-year Nifty SIP returns have reduced by almost 50%
- My expenses have increased significantly due to lifestyle creep than due to inflation (of old expenses). New expenses are the enemy! Updating this is crucial. We cannot assume
- I have somehow managed to achieve financial independence in spite of 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 for 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, if it is right or wrong, goes away automatically. Two caveats though.
(1) Our inflation estimate should be in line with how our actual expenses increase and not close to what the govt 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 fool-proof as possible. So it is better to expect less (return) and more (inflation) than to be disappointed.
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