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The Never Ever Assumption? July 9, 2008

Posted by shaferfinancial in Uncategorized.
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When speculating about the future, assumptions matter, in fact they are the only thing that matters.  All those calculators on various blogs and financial firm web sites contain blanks for some essential assumptions for folks to put it and get out how much money they might have for retirement.  You input assumptions like rate of return, monthly input, time to retirement or age and out comes assumptions of how much money you would have.  But it means little because all those assumptions are totally speculative.  And what do we humans do when we speculate, mostly we put in numbers that are we wish for.  People can speculate about those items all they want, but what gets missed is the underlying assumptions.  Assumptions like folks will make monthly inputs into their retirement plan for 30 years (yea right). 

The really big one is what I call the never ever assumption.  The built in assumption that you will never ever use the money in your retirement account.  What, you say?  Yes, you see all these calculators assume an average rate of return, but that is not how it works in real life.  In real life any investment will have variability.  In other words some years you will get a negative return, some years a meager couple of percentage points and some years 20%.  You can only use the average rate of return if you assume you will never access your account.  Say, for example, you retired in 2004 and started accessing your money in some mutual fund.  Well, you mutual fund’s performance since 2000 had been negative so your average return had been severly curtailed.  But you need some money now.  In order for it to get back to that average return you would have to leave your money in for the rebound.  But you can’t.  Now if you retired anywhere in the last 8 years you have some serious making up to account for.  In fact the whole decade will likely show little capital growth.  Conversely if you retired in the early 1990’s then you have a much higher average return because the first 10 years of your retirement saw your accounts going up magnificiently.  Bottom line, if you are depending on this money for retirement then you need to hope that you retire in a good time for returns or you have issues.  Funny thing about averages, they really don’t tell you much unless there is little variability.

Here is the other issue.  The rate of return for the last few years are critical.  Say you have 3 years to retirement and $500,000 in your account.  For the last 3 years the rate of return is 8%, 22%, and 12%.  Great you have over $737,000.  But less say instead your last three years looks like this -12%, 5%, -7%.  Instead you have around $430,000.  Quite a difference!  Now remember both of these have equal possibilities given the variability of mutual funds.  So financial planners say you should give up on some returns to control the varibility as you approach retirement.  But remember that assumption you put in 20 years ago.  What happens to that if you start giving  up on returns as you approach retirement.  Then your overall returns go down at the most critical time.   Hopefully you now understand that the rates of return are much more critical as you approach retirement and the first few years of your retirement.  And this is the most highly speculative time as it is the time period furtherst removed from now.  Finally, this is the time financial planners encourage you to reduce risk (variability) and the corresponding rates of return!

Best have a plan for those years other than a prayer for good rates of return!

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