What Biases are Driving Retirement Planning Today?
When it comes to retirement, there are many factors and variables to consider, but do we really understand how each impacts our desired outcomes?
Of course not. Nobody really knows what the future holds and what events will unfold over the course of our retirement years. The situation becomes even more complex when taking into consideration the biases and emotions people bring to retirement planning. Whether you’re a planner or an individual planning on retiring, knowing how you think about money and planning can lead to a better outcome.
With that said, here are some of the biases or mistakes we have seen impact clients’ decisions over the years:
Underestimating Income Needs
You may have heard the rule of thumb about saving enough for retirement to provide for 60 to 80% of your pre-retirement income, plus factoring in for inflation over the course of your retirement years.
But is that what is truly needed? Often when clients are asked about how much they spend, they remember big-ticket items like car payments, mortgages, credits cards, and utilities. However, it is easy to forget the numerous small expenditures over the course of the year that can add up to meaningful dollars.
Will income needs go down after retirement? Does spending really drop the month after retirement? Understanding personal income needs, wants, and wishes will help answer these questions. Additionally, recent studies on retirement income needs show that, while the cost of medical care goes up over one’s lifetime, income needs in other areas often go down. That will more than offset the rising healthcare costs. This trend does not, however, account for unexpected events, such as long-term care needs or major medical support needs.
Using Market Averages to Project into the Future
Since March 2009, the S&P has grown from roughly 640 to now over 4,500. That’s a sevenfold increase in a little over 12 years and represents an average annual return of over 17%, which can skew perceptions when it comes to retirement. Investors can have short-term memories when it comes to investing and when that happens, planning can go awry when the markets change.
There is also the misunderstanding that an average return is a good point of reference for market forecasting. This is more accurate during one’s accumulation phase of life. But during the distribution phase, when retirees begin withdrawing money from their accounts to live on, something can happen that makes investment outcomes significantly different for different retirees.
Let’s say two people began their retirements with identical investment balances. Each year they withdrew the same amount of money from their portfolios and after many years passed they could look back and see they had the same average return for those years. But oddly enough, one retiree has a significantly higher portfolio balance than the other.
It’s because of the sequence of the returns they each experience. If one retiree’s investments provide significant positive returns in the early years of retirement and negative returns in the later years, that person could still finish with more money than when they started. However, if you flipped the sequence of returns for the other retiree, where they experienced significant losses early on and then had the positive returns in the later years, they could be left with much less money than when they started.
This is a tough concept for some people to grasp, but an important one to understand because it reveals the risk retirees run by using a simple average rate of return in forecasting their retirement.
Thinking that Bonds are Safe
We are in a unique period with historically low interest rates, which leads to this question: Just how “safe” are bonds today? Sure, there may be little chance you will lose your money by buying treasuries, but what about the impact on your investment by other factors such as inflation? You may get your money back, but it is conceivable that the purchasing power of that money will be reduced. That means you are losing the ability to keep pace with inflation when this happens.
Take it one step further. What if you own bond mutual funds where you do not have control over the buying and selling of the bonds within the funds? Many investors feel they may have a safe holding, but if interest rates rise, the value of many bond funds will go down. This becomes even more challenging over time, as investors receive their statements and see that the “safe” piece of their portfolio in bond funds has a negative rate of return. They start to sell these holdings, which can cause a further downward trend.
This is not to say bonds should not be part of a portfolio. Just don’t get caught up in the misconception that bonds are safe. They are safer or less volatile on average than equities, but safe can be a relative term when it comes to investing.
Feeling the Need to be Conservative at Retirement
Many retirees feel that once they retire, they should have significantly less allocation in stocks. But if someone retires at age 65, they could have decades ahead of them that they need to continue to plan for. This includes years of inflation that need to be taken into consideration to maintain one’s lifestyle, and stocks provide one of the better inflation hedges.
When people reduce the percentage of their portfolio invested in equities, they also reduce the opportunity to keep pace with inflation. We happen to be at a point in time where inflation has been lower than the average of roughly 3.2%, but we can’t count on low inflation in the future.
We are also at another interesting point in our economic cycle right now. Stocks are paying a significant premium on their yield over bonds. The S&P 500 is paying roughly 1.3% while the 30-day Treasuries have been paying less than 0.10%, and 10-year is paying approximately 1.3%. With some selective analysis on investment, it would be easy to create an income of greater than 3% on your stock holdings. This does not mean that volatility will be less, but there is greater certainty that the income will be higher in the upcoming years for now.
Failing to Understand the Pros and Cons of Annuities
This is one of those touchy subjects because it carries a lot of emotions for some people. There are often strong beliefs around annuities on both sides of the table, so much so that even the investment managers play on this emotion in their marketing efforts.
First, there are so many types of annuities that it is difficult for anyone to either fully rule them out as an option or to promote them as the holy grail of investing. The reality is that it depends on the investor. Some investors would appreciate the characteristics that some annuities may be able to provide beyond the tax-deferral ability, such as income and/or principal protection.
When used properly, AND for the right client, annuities can provide peace of mind to investors. However, all annuities come with rules that one needs to live by for the protections to stay in place. So too often annuities are not understood when purchased and thus they break the rules and the benefits go away. After paying the higher fees and often the missed opportunity of receiving potentially higher rates of returns, these clients can end up disappointed in the product they purchased.
Perceiving that Options Trading Always Equals Increased Risk
Options are becoming more mainstream because technology is allowing managers the capability to scale custom trading that was once available only to large institutions and endowments. However, when asked, many investors generally perceive that options trading increases the risks in their investment portfolios. But does it?
The answer is: It depends. Investopedia defines risk as “the chance that an outcome or investment’s actual gains will differ from an expected outcome or return.” When structured properly with the goal of reducing risk, options can be used to buffer or protect some of the downside of an investment, thus lowering overall risk in a portfolio. Additionally, options can be used to further enhance the income generated by a portfolio, which can assist in distributions to meet retirement needs over time.
Assuming They Don’t Need Life Insurance Anymore
We often hear people say, “Once my kids are out of the house and my house is paid off, I don’t need life insurance anymore.”
For traditional purposes, that may or may not be the case. There are ways life insurance helps that people don’t always consider. For example, insurance can continue to play an important role in selecting different pension options. Also, retirees may feel they wish to live off the interest of their portfolio because their goal is to leave the principal of the investments to their heirs. Often, with the use of insurance, retirees can live off more of their investments and spend down principal, while maintaining insurance for their legacy goals.
These products can allow for a better lifestyle for the retiree, who can sacrifice less of their ability to spend, while still providing the same or greater transfer of assets to their heirs.
This is not meant as an exhaustive list of biases and considerations we have seen, and many of these topics can require longer discussions. Some have deep rooted thoughts or emotions associated with them, whether that’s from someone’s personal experiences, from something passed down by their parents, or is based on fractured knowledge obtained from other sources that retirees and investors base planning decisions around. The reality is that, 20 years from now, we could look back and state exactly what was the best course of action one should have taken for their retirement plan.
Of course, that’s of no help, so the next best alternative is to go into retirement planning with a process. That process should:
- Identify and address your own biases.
- Create a platform to fully discuss an open and honest conversation as to what is most important to you in retirement.
- Evaluate the plan around protection, investing, taxes and the variables that go into the forecasting of the plan.
Finally, creating a well thought out retirement roadmap can sometimes be the easiest part of the process. Continued collaboration, active management, and making adjustments along the way will often deliver the best results.