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Retirement planning: Yes, you can be too conservative

Christine Benz  |  13 Sep 2016Text size  Decrease  Increase  |  

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There's a real risk that well-meaning retirees and retirement savers can over-save and under-spend, according to Morningstar's US-based director of personal finance Christine Benz.

 

When it comes to retirement planning, "hope for the best, plan for the worst" is a reasonable motto.

Given 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, there's a risk 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 per cent 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 that government pension benefits won't be there for them, or that they're assuming their portfolios will return just 2 per cent in their 25-year runway to retirement.

Of course, I realise that it seems ridiculous to discuss being too conservative about retirement planning when many have saved far too little for their retirement.

But there's also a segment of the population that could be playing it too safe with their retirement-planning assumptions, and those overly 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 labour or simply worry about running out of money more than they need to.

Here are some of the key ways 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 government pension benefits won't be there

Maintaining conservative assumptions about government benefits such as the Age Pension may seem like an extremely prudent assumption.

But assuming that retirees 40 years hence will get nothing from the government is a pretty big stretch, given that some fairly simple, albeit controversial, fixes--such as means-testing, raising the full retirement age or capping benefits for high-income earners--can put an overextended government program on firmer footing.

And even if a young accumulator is convinced he or she won't get anything from the Age Pension, that assumption necessitates a heroic bump-up in saving relative to the accumulator who assumes she'll get something.

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. That's 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 ultra-low percentage, like 2 per cent or 3 per cent, 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, or who want to be sure to leave something to their children or other heirs. They'd rather be frugal than jeopardise 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 per cent withdrawal, it's not at all kooky for an 85-year-old to do so.

3) Gunning for a 100 per cent 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 would say 0 per cent. In other words, they want a plan with 100 per cent 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 short-term securities, 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 per cent to 90 per cent are acceptable.

Venturing into higher-risk investments takes the probability of success below 100 per cent, 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.

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 lacklustre 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 per cent.

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 the returns they earn from their stock and bond portfolios beyond that time frame will be more in line with historical norms.

Although stocks have historically returned roughly 10 per cent and bonds about 5 per cent, investors with very long time horizons may want to give those numbers a small haircut to account for muted near-term expectations; 7 per cent to 8 per cent seems reasonable for stocks, and 3 per cent to 4 per cent for bonds.

Based on those assumptions, if I were estimating the very long-run return expectation for a portfolio with 60 per cent in equities and 40 per cent in bonds, I'd use 5 per cent to 6 per cent.

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Christine Benz is Morningstar's US-based director of personal finance.

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