What if inflation is higher than you expect in the future? What if tax rates increase?
Retirement planning is an ongoing process that involves many variables to ensure it's done correctly. While an initial retirement projection might be a good start, you need to have a plan for when your assumptions are incorrect. For example, what if inflation is higher than you expect in the future? What if tax rates increase? These are just two of the seven "what if" scenarios that I'm going to cover in this blog post, along with ways to plan ahead to reduce or eliminate any stress about the long-term success of your plan.
To best explain these "what if" scenarios and their impact on your financial plan and retirement, we're going to take a look at our financial planning software and a couple of clients that we work with here at Spark Wealth Advisors. Their names have been changed, of course, for privacy reasons, and we've simplified some of the numbers, but I think this will be the easiest way to visualize the impact of certain "what if" situations.
Katie and Kevin, aged 66 and 64 respectively, are planning to retire next year. Here’s a snapshot of their financial situation:
To analyze their retirement plan, we use a Monte Carlo analysis. This is a simulation of 1,000 different scenarios using inputs such as current savings, investment allocations, desired retirement age, and spending goals. It projects the likelihood that Katie and Kevin will have enough money to live on for the rest of their lives given these variables.
Their initial plan showed a 47% probability of success – meaning there's a 47% chance they'll have enough money to last their lifetimes. One of the issues I have with Monte Carlo simulations is that they assume no changes are made from now until the end of their lives. It’s like saying there’s a hole in our boat and there’s a 47% chance we’re going to make it back to shore, but do nothing to try to plug the hole. A better way to frame it, in my opinion, is that there's a 53% chance they'll need to adjust something along the way to prevent running out of money.
We made several adjustments for Katie and Kevin:
These adjustments increased their probability of success to 80%, making it a much more comfortable starting point.
Retirement usually spans around 30 years, and a lot can change in that time. To ensure their plan is robust, we perform a stress test on Katie and Kevin’s retirement plan. Here are the seven "what if" scenarios we consider:
Baseline Assumption: The market does not drop at retirement.
What If Scenario: The stock market drops by 20% at the start of retirement.
Planning Tips:
In Katie and Kevin’s case, their probability of success is still 71% even if the market drops, indicating a solid plan.
Baseline Assumption: Today's tax rates, factoring in the expiration of the Tax Cuts and Jobs Act in 2026.
What If Scenario: Tax rates increase by 20%.
Planning Tips:
With these strategies, Katie and Kevin maintain a 77% probability of success, showing taxes are not a huge threat to their plan.
Baseline Assumption: No cut in Social Security benefits.
What If Scenario: Social Security benefits are cut by 20%.
Planning Tips:
This scenario significantly impacts Katie and Kevin’s plan, but delaying Social Security benefits helps mitigate the risk.
Baseline Assumption: Life expectancy of 81 years for men and 84 years for women.
What If Scenario: Living to 95 years.
Planning Tips:
Living longer brings Katie and Kevin's probability of success below 60%, indicating the need for careful planning.
Baseline Assumption: Long-term inflation at 3%.
What If Scenario: Inflation at 4%.
Planning Tips:
Higher inflation reduces their probability of success but can be managed with proper investment strategies.
Baseline Assumption: $6,000 per year per retiree for healthcare expenses.
What If Scenario: Health expenses are 20% higher.
Planning Tips:
Health expenses are a significant concern but planning with conservative estimates keeps their probability of success at a comfortable level.
Baseline Assumption: Expected portfolio return of 6.6%.
What If Scenario: Returns are 1% lower.
Planning Tips:
Even with lower returns, starting with conservative estimates helps Katie and Kevin maintain a resilient retirement plan.
Whether you're a DIY retiree or working with a financial adviser, consider these "what if" scenarios to ensure you have a plan in place if any or all of them come true. The goal is to reduce stress and lead a fulfilling retirement.