Monday, January 24, 2011

Forecasting is Tough, Especially About The Future


A couple of years ago I passed the exam to become a Certified Financial Planner (CFP).

I thought it would be useful to help my clients not only with their investment decisions but also to be able to offer other kinds of financial advice as well.

And indeed it has been helpful. More and more these days I find that clients are more interested in making sure their financial plans are sound rather than focusing on market outlooks and the like.

However, one of the things you quickly discover when you are trying to help someone plan for the future is that so many of the "answers" you come up with depend on your assumptions.

For example, at the end of the 1990's, it was conventional wisdom that one should put a significant part of retirement assets in stocks, since equities were clearly the best way to grow assets. Indeed, after 17 years of 19% compounded returns (which was the case at the end of 1999), using a 12% per annum growth rate number for equities in the planning process seemed somewhat quaint and conservative.

Well, we all know what happened. For the last 10 years, the S&P 500 has returned 15% (including dividends), or less than you might have earned by buying long-term bonds (where you almost doubled your money in the same time period).

For someone who retired in 2000, this meager performance wasn't just a curious factoid: this had a real impact on their lifestyle.

Another consideration was highlighted in an article published this weekend by the New York Times. The article discusses how important the return on your assets play not only while you are working but in the final years prior to retirement. Here's an excerpt:

The problem is that even if you do everything right and save at a respectable rate, you’re still relying on the market to push you to the finish line in the last decade before retirement. Why? Reaching your goal is highly dependent on the power of compounding — or the snowball effect, where your pile of money grows at a faster clip as more interest (or investment growth) grows on top of more interest. In fact, you’re actually counting on your savings, in real dollars and cents, to double during that home stretch.

But if you’re dealt a bad set of returns during an extended period of time just before you retire or shortly thereafter, your plan could be thrown wildly off track. Many baby boomers know the feeling all too well, given the stock market’s weak showing during the last decade.

With Retirement Savings, It’s a Sprint to the Finish - NYTimes.com

I would add one additional point. The correct withdrawal rate from your retirement account can also be dependent on the returns on your assets in your early years of retirement. If the market tanks right after you need the money, for example, you could find yourself running out of money if you don't change your withdrawal percentage fairly significantly.

Of course, if you're an optimist, if the market rises right after retirement, life could be better than expected.

Put another way, being a CFP tells you that the one of the most important points to remember in retirement planning is to consider various alternatives - the future is always uncertain, and probably different than anyone expects.