Prior to entering retirement, you need a well-crafted retirement plan that is stress-tested to provide guidance to make smarter financial decisions. While your plan and stress test yield valuable information, they may quickly become stale. Your retirement strategy needs to be updated regularly and be dynamic in three key areas – market expectations, portfolio allocation, and spending – to help make the most of what you have.
Dynamic Market Expectations
Whenever you are making retirement projections, you must assume some expected return on your investments over time to gauge whether you have enough and how much you can spend. These market expectations vary.
Going all the way back from 1926 through July 2018, history says you would have earned 5.1% by owning US Treasury Notes and 10.2% from the S&P 500. Recently over the last five years, the returns have been 1.3% and 13.1%, respectively. So, what to use for your projections – history or recency?
Neither is the answer. Current bond yields – 2.9% for the notes – are generally a good starting point for expected bond returns. Stock returns are more complex to forecast, but they can be decomposed into component return parts. Some components are fairly stable (like dividend yield) where others (like earnings growth) are more uncertain. Yet, using this approach on an ongoing basis to look into the future can yield better retirement projections and spending advice.
Your portfolio allocation – or the recipe you follow to combine your investment ingredients – also needs to change in light of market expectations and as a result of the stress test of your retirement plan.
Ten years ago, coming out of the Great Recession, U.S. stocks had much higher expectations compared to bonds. Thus, favoring stocks over bonds made sense. The S&P 500 has been positive for nearly ten years in a row. Many forecast U.S. stocks to provide better returns than bonds but by very little over the coming years. So, is the marginally higher expected return for U.S. stocks worthwhile to pursue despite the substantially higher risk?
Perhaps even more important, when you stress test your plan, you will measure both your need and ability to take risk. If you lack the ability to take risk, simply put you should not do so, or you risk severe cutbacks to your lifestyle. The inability to take risk, generally means having more bonds in your allocation.
Conventional wisdom suggests having 100 less your age to derive your stock allocation. This is a rule of thumb that not only ignores the necessary stress test but also contradicts recent studies. For instance, Dr. Wade Pfau found in 2013 that rather than continuing to decrease your stock allocation as you age, an increasing stock allocation historically reduced the chance that your plan does not meet its spending goals.
Your retirement spending may need to be dynamic as well. If things don’t go as well as you plan or you have unforeseen and unavoidable expenditures, you may have to reduce spending in other areas.
Suppose your plan has five goals that you rank in order of importance to you: essential expenses, healthcare, car purchases, discretionary spending, and travel. Through your planning, you determined in advance and based on your preferences, if you have to reduce spending, it would come from discretionary spending.
Your plan, investments, and income strategy are not ‘set it and forget it.’ Life changes as do economies and markets. By understanding the dynamic nature of the dynamic variables that will drive the success or failure of your plan and using this information to make smarter decisions, you can put the odds more in your favor for a successful retirement.