Investing Specialists

Retirement-Planning Assumptions: Yes, You Can Be Too Conservative

Christine Benz

When it comes to retirement planning, "hope for the best, plan for the worst" is a reasonable motto. Given that many retirees fear running out of money more than they fear death, it's only prudent for them to manage their retirement plans with a healthy appreciation for all that could go wrong.

However, I think there's a risk--albeit an underdiscussed one--that well-meaning retirees and retirement-savers can take caution too far. For example, I've run into 75-year-old retirees who, in the interest of playing it safe, are spending just 2% of their portfolios annually; at that pace, they're very likely to leave a very large kitty behind. That may be what they want, but it may not be. In a similar vein, I've met 40-year-old accumulators who tell me that they're certain Social Security won't be there for them, or that they're assuming their portfolios will return just 2% in their 25-year runway to retirement.

Of course, I realize that it seems ridiculous to discuss being too conservative about retirement planning in an era in which the median 401(k) balance, per Vanguard's How America Saves report, was just shy of $30,000 in 2015. But there's also a segment of the population that could be playing it too safe with their retirement planning assumptions, and those too-conservative assumptions carry costs. Accumulators who are too conservative in their retirement-planning assumptions might short-shrift other pre-retirement goals because they're trying to swing a gargantuan savings rate, while overly parsimonious retirees might fail to enjoy the fruits of their labors or simply worry about running out of money more than they need to.

"One risk everyone talks about is failing--going broke when you're older--but another risk that's rarely talked about is the risk having some big pot of money when you die," said David Blanchett, head of retirement research for Morningstar Investment Management. "While this isn't a risk in a traditional sense, it means you haven't best utilized your money to fund retirement and consumption."

Here are some of the key ways that retirement-savers and accumulators run the risk of being overly conservative in their retirement assumptions; these items are common inputs in retirement savings calculators and software programs.

1) Assuming Social Security won't be there.
"I do not incorporate Social Security benefits into my retirement forecasts and future cash flow models. The reason being is because we all know how irresponsible Washington has been with the Social Security Fund. Plain and simple." So commented a reader on a recent article about what sort of assumptions younger investors should make about their future Social Security benefits.

Considering that the Social Security trust fund is projected to run dry in 2034, maintaining conservative assumptions about Social Security benefits may seem like an extremely prudent tack. But assuming that retirees 40 years hence will get zip, nothing, nada from Social Security is a pretty big stretch, given that some fairly simple, albeit controversial, fixes--such as means-testing, extending the full retirement age, or raising the cap on income that's subject to Social Security tax--can put the program on firmer footing.

And even if a young accumulator is convinced he or she won't get anything from Social Security, that assumption necessitates a heroic bump-up in saving relative to the accumulator who assumes she'll get something. Using the Ballpark Estimate calculator and assuming no help from Social Security, a 25-year-old earning $40,000 a year and receiving a 3% annual pay increase would need to save nearly 25% of her annual income, from now until retirement age to help supply in-retirement cash flows equivalent to 80% of her final year's working income. That's a heavy lift, especially for individuals with more modest salaries who must steer a healthy portion of their paychecks to necessities. By contrast, the accumulator who assumes the status quo for Social Security benefits would need to save 6% of her income annually to achieve the same income-replacement rate. An accumulator who assumes a middle ground--that a Social Security benefit will be there but reduced by a pessimistic one third--would need to save 12% of her annual salary to achieve an 80% income-replacement rate.

2) Taking a too-low withdrawal rate later in retirement.
Many retirees and pre-retirees have gotten the memo about the risk of overspending in retirement, especially if we encounter a period of muted future market returns. Retirees who encounter a bad market in the early years of their retirements and overspend at that time risk permanently impairing their portfolios' sustainability, because too few assets will be in place to recover when the market does. I've talked to many retirees who withdraw a fixed percentage of their portfolios year in and year out to help tether their withdrawals to the performance of their portfolios; others tell me they use an ultralow percentage, like 2% or 3%, even well into their 70s and 80s. Conservatism is their watchword when it comes to portfolio withdrawals.

That's fine for retirees whose portfolios are large enough to afford a decent standard of living with a modest percentage withdrawal rate. And as noted earlier, some retirees may prioritize not spending through all of their assets so that they can leave something to their children or heirs; they'd rather be frugal than jeopardize their bequest intentions.

But for other retirees, especially those who are well past the danger zone of encountering a weak market early in retirement, a higher withdrawal rate is reasonable, especially if it affords them expenditures that improve their quality of life. While it's decidedly unsafe for a 65-year-old to take, say, an 8% withdrawal, it's not at all kooky for an 85-year-old to do so. "The 4% rule" for retirement spending, while not perfect, does a good job of scaling up spending as the years go by; the initial dollar-amount withdrawal gets adjusted upward year after year to keep pace with inflation.

3) Gunning for a 100% probability of success.
If you were to ask the average person what probability of failure in their retirement plan they might be comfy with, chances are they'd say 0%. In other words, they want a plan with 100% odds of being successful. The risk of spending their later years destitute--or having to rely on adult kids or other family members for financial support--is simply too terrible to ponder.

But retirement-planning experts say that unless investors are willing to accept some probability of failure, their only option is to hunker down in very safe investments, such as cash and Treasuries, and put up with an unpalatably low spending rate (or an exceptionally high savings rate for accumulators). Instead, most retirement-planning specialists believe probability-of-success rates of 75% to 90% are acceptable. Venturing into higher-risk investments takes the probability of success below 100%, but it also allows for the possibility of a higher return. If a retiree needs to course-correct by reining in spending, that's not going to result in a catastrophic change in his or her standard of living. This graphic nicely illustrates the interplay between asset allocations, spending rates, and probabilities of success.

4) Assuming too little help from the market if you have a very long time horizon.
Stock-market valuations, while not ridiculously lofty, aren't cheap, either; that portends lackluster returns from the asset class over the next decade. Meanwhile, current yields have historically been a good predictor of bond returns; the Barclays Aggregate Index is currently yielding less than 2%. For sure, those ominous signals suggest knocking down your return expectations for both asset classes for the next decade or so.

On the other hand, investors with longer time horizons to retirement may experience muted results over the next decade or more, but for them it's safer to assume that the returns they earn from their stock and bond portfolios beyond that time frame will be more in line with historical norms. Although U.S. stocks have historically returned roughly 10% and bonds about 5%, investors with very long time horizons may want to give those numbers a small haircut to account for muted near-term expectations; 7%-8% seems reasonable for stocks, and 3%-4% for bonds. Based on those assumptions, if I were estimating the very long-run return expectation for a portfolio with 60% in equities and 40% in bonds, I'd use 5% to 6%.