Are Your Assumptions of the Future Reasonable?

When I’m with my friends, we generally do not talk about retirement or retirement planning.  We might discuss travel destinations, IF we were to have time, money, and flexibility to go all at the same time, but discussions of future financial sustainability seem to be few and far between.  I was then surprised when one friend asked me if I would help her re-allocate her 401K and help her understand her retirement prospects.  It turns out, many of the assumptions she has about the future, seem to be out of line with the financial realities.  I’m guessing my friend is fairly typical, and many other people are basing their retirement plans on poor assumptions:

–What investment rate are you using — My friend was assuming that her investments would earn 10% per year.  While some investments may have returned 10% over the past couple of years, it is unlikely that the major asset classes of stocks and bonds will be able to sustain double digit growth, year after year.  After adjusting the financial calculators for more reasonable return rates (closer to 6%), the amount needed for retirement can change dramatically.

–What expenses do you expect in the future – very few people that I know adequately account for inflation in their future expenses.  Although the cost of many basics, like food and clothing, have historically not risen too much, this may not always be the case.  In addition, most people underestimate their healthcare costs.  Keep in mind that healthcare premiums, new drugs and treatments continue to rise beyond the inflation rate.  Also, most people spend more on healthcare as they age.

–What will be your source of income — My friend had invested a large portion of her savings in a house, believing that it would be a good investment for the long-run.  If the house appreciates in value, this is the case, however, unless the house is sold or rented out, it doesn’t generate income.

--What are your expectations for social security or a pension — in this particular case (and only this case), my friend was too pessimistic.  Social security may not be able to pay out the full amount that retirees are receiving today, but it is unlikely to be zero.  With respect to pensions, my friend has never worked for an employer that provided a pension. Fortunately, this forced her to open a 401K several years ago and a portion of every paycheck goes to this.