When developing a client’s financial plan, you will have to make certain key assumptions, especially for the plan’s retirement segment. One assumption that affects every aspect of retirement money is your client’s life expectancy and, if applicable, how long your client’s spouse may live.
One thing you should do is to avoid the planning trap of basing retirement income needs on a “Life Expectancy at Birth” table. This table is obsolete, so do not use it. Even the most current edition incorrectly projects that by 2025, most Americans will live to age 79. Today, retirees have already surpassed the 80-year mark, and 24 years from now, life expectancy will be substantially higher.
Instead, view life expectancy in terms of how long the money will have to last should your client live beyond age 65. Currently, the average life expectancy is between the ages of 85 and 90. Perhaps an even better strategy is to consider the average life expectancy of one member of a couple, both of whom make it to age 65. Now you are planning for a client whose average life expectancy is about age 93. In this context, average assumes that one half of the couple is dead, and the other half is still alive.
In my practice, I assume that my older clients—those who are 55 and older—will live to age 100. For Baby Boomers, I increase that projection to age 110. Whatever measure you use for your clients, be sure there is enough income flow after the first spouse dies.
Estimating future inflation is another key planning assumption. If the past is prologue, here is what we know:
- Inflation has been all over the place, and
- There’s been no deflation for the past 45 years. For my clients, I currently assume a 3 percent rate for the next 10 years and 3.5 percent thereafter.
Future rates of return
The next key assumption is a whopper: What does the investment portfolio’s return rate have to be to provide enough money during a lifetime? This involves asset allocation and risk tolerance. You should avoid the common pitfall of recommending that clients invest too large an amount of their portfolios in fixed-dollar vehicles like bonds, money markets and CDs. This produces the need for a much larger asset base.
Most stockbrokers recommend a 60/40 stocks-to-bonds ratio, which is only appropriate when the investor has a five-year financial time horizon. This means that in five years, the money is no longer needed, usually at death. With clients living longer, healthier lives these days, the 60/40 ratio should only be applied when a client has reached his/her mid-80s or early 90s, but not before.
For the past 20 years, I have been recommending a pre-retirement 90/10 allocation-90 percent stocks and real estate to 10 percent fixed dollar. Future columns will explore this allocation in greater depth. Further, I assume an 8 percent after-tax return rate for retirement projections. Of course, if a client requests an estimated higher or lower return rate, I will reluctantly oblige. Using a current after-tax return rate is important because much of a retiree’s money often remains in qualified plans, where it can benefit from long-term tax deferral. In addition, remember that 8 percent is a realistic goal only if your client allocates only a small portion of the entire portfolio to fixed-dollar investments.
Next month, tune in to find out how to calculate retirement-income needs using two methods: replacement ratio and actual expense. You will learn the pros and cons associated with both calculations.
Donald Ray Haas, CLU, ChFC, CFP, MSFS, of Southfield, Mich., has been an insurance agent and financial consultant for 45 years. He can be reached at 248-213-0101 or at Donaldhaas@aol.com.