Retirement Assumptions: Will They Make An Ass Out Of You Or Me?

Retirement Assumptions: Will They Make An Ass Out Of You Or Me?

Financial planners need to use assumptions about the future to paint a realistic picture for their clients. Since we don’t have a crystal ball, most rely on the projection and assumption guidelines put forward annually by FP Canada.

These assumptions include estimates about inflation, investment returns, life expectancy, wage growth, borrowing costs, etc. Note that these assumptions are meant to approximate an average over 10+ years. Forecasting any economic variable over a short period of time is pretty much impossible, but while the short-term may be volatile (hello 2020s), long-term trends are a bit easier to predict.

Take inflation. Sure, in the past two years we have experienced higher than normal inflation. It might be tempting, then, to increase the inflation expectations in your plan to match the present (or near past) environment. But that would be a mistake for two reasons:

  1. Nearly every central bank in the world is working to get inflation back down to a steady and predictable 2%. Canada is also an aging, developed, slower growth economy that lends itself to lower interest rates and lower inflation over time. Furthermore, in looking at two-year rolling averages over the past 60 years, the inflation rate was at 3% or lower nearly 75% of the time. 
  2. Inflation affects other variables. Increasing the inflation rate in your retirement plan also means that your CPP and OAS benefits will increase at the same rate. Same for those with defined benefit pension plans that offer inflation protection. Higher inflation would also lead to sustained higher interest rates, which increase the rate of return for assets like cash, bonds, and equities. In summary, we can’t change one assumption in isolation.

FP Canada assumes that inflation will average 2.1% annually over the long-term, and I don’t have any reason to disagree.

This article explores other retirement assumptions used for financial planning projections and explains the rationale behind them. I’ll also share some common objections or misperceptions that I hear from clients about some of these variables.

Life Expectancy

FP Canada suggests using a projection period for clients where the probability of outliving their capital is no more than 25%. If we assume the average life expectancy is about 81 years for Canadian men and 85 years for Canadian women, then by definition half of men and women will live longer than the average. 

Then there’s your probability of survival if you’ve already reached a certain age. For example, a 60-year old male has a 25% chance of living to age 94 and a 50% chance of living to age 89.

That’s why I run my planning projections to age 95 as a default (unless there are specific health or genetic reasons to move that age up or down). I want to stress-test your plan to make sure that you have enough resources to last a long and healthy retirement.

And, no, it’s not sensible to change your otherwise normal life expectancy to 75 in order to retire earlier and spend more money. Taking up smoking (or sky diving) is not a sound financial plan.

Investment Returns

I don’t ascribe to the Dave Ramsey approach to investment returns – thinking you can earn market returns of 12% per year indefinitely. FP Canada offers a more realistic estimate of between 6.2% to 7.4% per year before fees.

If we assume a globally diversified portfolio made up of 30% Canadian stocks, 62.5% US and International stocks, and 7.5% emerging markets stocks, we get a projected rate of return of about 6.5% before fees for an all-equity portfolio best represented by Vanguard’s VEQT.

FP Canada projects that aggregate bonds will return 3.2% annually (again, before fees). If we apply that to the classic balanced portfolio of 60% stocks and 40% bonds (best represented by Vanguard’s VBAL) we get a projected rate of return of 5% before fees.

This closely aligns with the investment return assumptions I use for planning purposes. I assume 6.1% net of fee return for equities, 3.1% net of fee return for bonds, and a 4.9% net of fee return for a 60/40 balanced portfolio.

For cash, I assume 1.6% – or inflation minus 0.5%. The idea is you keep your savings in a high interest savings account to capture the best rate of return on cash that you can. It’s not in a chequing account or big bank savings account earning nothing, and it’s not stuffed under your mattress.

By the way, it should go without saying that these returns represent a long-term average rate of return. Investment returns can be incredibly volatile from one year to the next. But you don’t abandon a perfectly sensible and diversified portfolio after one bad year. Similarly, you don’t get excited and prepare your resignation letter early after one good year in the markets.

Wage Growth

Clients still in their working years are often puzzled when it comes to forecasting their expected wage growth. They typically don’t want to assume that their income will increase at all, let alone by the rate of inflation.

They’re even more puzzled when I tell them that the typical wage growth is inflation plus 1% (or 3.1% per year). That’s right, in normal times your wages will outpace inflation. That’s a fact.

I get it. I went through five years of wage freeze hell in the public sector. But when you account for cost of living adjustments and potential promotions or increases from job switching throughout your career, it’s not out of line to think that your wages can grow by 3.1% per year on average over the long term.

Still, try explaining to someone making $100,000 today that they’ll be making $215,000 in 25 years and they’ll stare at you in disbelief.

Spending in Retirement

Many people have no idea what they’ll spend in retirement. A helpful starting point is to determine what you’re spending in your final working years. Most of my clients want to maintain their existing standard of living, if not enhance it with some extra money for travel and hobbies.

We also may have heard that retirement spending keeps pace with inflation during the “go-go” phase of retirement, then reduces during the “slow-go” phase (inflation minus 1%), and and then levels off during the “no-go” phase (no more inflation adjustments).

While this sounds intuitive, I’m not a fan of this approach to retirement spending because I don’t want to arbitrarily impose spending cuts for my clients at age 75 and 85 (for example). I can also easily see spending on travel and hobbies being replaced by in-home nursing care and mobility aids as you age. 

For this reason, I keep spending increasing with inflation to age 95 when possible.

I also encourage clients to think about one-time expenses that will likely occur throughout their retirement. The big four items include new vehicles, home renovations and repairs, financial gifts to kids, and bucket list travel and experiences. We weave these expenses into the plan as needed.

Housing in Retirement

A big question for homeowners is what to do with their paid-off home in retirement.

Sometimes, it’s painfully clear that the client will need to access their home equity by downsizing, selling and renting, or using a reverse mortgage.

More often, the client has enough resources to maintain their lifestyle without selling the home and so we assume they remain in their home (or home of equivalent value) for their lifetime. There’s no use trying to predict their health situation at 85 or 90 and the need to move into a retirement facility. The home is there and equity can be tapped if needed.

Still, if the goal is to maximize spending or “die with zero” then clients should consider the eventual sale of their home to add the proceeds to their savings and investments for consumption.

Final Thoughts

There are a lot of unknown variables that go into a financial plan. We need to use reasonable assumptions to help understand how you’ll use your financial resources over time to achieve your goals.

Assumptions should be conservative, but realistic. You won’t do yourself any favours expecting 12% returns on your investments. On the flip side, there’s no need to be pessimistic about the future and expect persistently higher than normal inflation, Great Depression-like returns, or low to no wage growth.

Finally, know that these are assumptions about what the world is going to look like in the future, but the world is surprising and unpredictable (hello 2020s). Check in on your plan and projections from time-to-time to make sure you’re still on track and course correct as needed.

Print Friendly, PDF & Email

12 Comments

  1. HK on November 21, 2023 at 5:48 pm

    Great common sense article! Thank you

  2. Andrew on November 21, 2023 at 6:26 pm

    Good article except “Still, try explaining to someone making $100,000 today that they’ll be making $215,000 in 25 years and they’ll stare at you in disbelief.” Unfortunately we have experienced – until the last year or so – significant wage deflation over the last 20 years. And yet despite the sickening amount of bs commentary claiming today’s generation will have less than their parents, our economy is stronger than ever and far, far wealthier than ever. Will my kids have to work to “own” a home? Yes, but that first home will be way, way nicer in terms of modern amenities and comforts than my first home. Anyone want to go back to the 80’s to see how life really was? Come on, wake up and realize how good we all have it in real terms when compared to any time in history.

    • Robb Engen on November 22, 2023 at 6:05 am

      Hi Andrew, I’m not sure what your argument is about that sentence. I’m not saying we don’t have it good today. I’m saying it’s hard for people to comprehend nominal growth over many years.

  3. Louie on November 21, 2023 at 11:19 pm

    This is a great article Robb, thank you.
    This confirms and quantifies the inputs that I should use for my retirement planning spreadsheet!

  4. David on November 22, 2023 at 5:52 am

    Thanks for the article Rob.

    Can you expand upon the logic applied by FP and yourself re. long-term equity returns? If the indexes have returned averages of ~10% over the last ~100 years, why is the go-forward view much lower (other than conservatism)?

    Thanks!

    • Robb Engen on November 22, 2023 at 6:02 am

      Hi David, if you click on the FP Canada link in the first paragraph they describe the methodology around equity returns, more specifically the equity risk premium – which they say has “decreased over time due to several non-repeatable factors (mainly diversification and globalization).”

      They include a table with expected returns going back to 2009 when the estimated return was about a full percentage point higher.

      Of course, they also look at the current environment. In 2009 equities were extremely cheap coming off the great financial crisis, which implies higher expected future returns.

      Today, equities are extremely expensive, which implies lower expected future returns.

      As for conservatism, they claim to only deduct a “safety margin of 0.50%” from their projections.

  5. david marshall on November 22, 2023 at 6:10 am

    Just a mathematics/statistics comment: Stating the AVERAGE life expectancy does not mean 50% will live longer than the average age! For example, if one person manages to live for 100 million years (an impossibility I know!) it would throw the average closer to 85/90 male/female but it does not mean that 50% would live past the new average age. Many fewer people would manage to live past the new average age.

    The MEDIAN age life expectancy would identify the exact 50/50 split where 1/2 the population would live past the median age and half would not. In my outrageous example above the median would almost certainly be unchanged but the average would change dramatically.

    • Robb Engen on November 22, 2023 at 11:42 am

      You’re right David – and I guess that answers the question of whether I’d make an ass out of myself in the post!

      Although I’d guess the average is much closer to the median when it comes to life expectancy – more so than something like average net worth – where between me and Bill Gates our average net worth is about $58 billion.

  6. Philip on November 22, 2023 at 9:24 am

    Lots of great information in this article, thanks for that.
    I understand the industry has to make assumptions however I always get hung up on things like “investment returns over 10 years” . I’m 65 and am living off my investments year to year. Unfortunately I can’t always take the 10 year view. If in that 10 yr period the first few years are terrible and then the market bounces back it could have a substantial impact on my retirement principal that would be difficult to recover from. It’s a delicate balance to have “safe” money in case this does happen vs making sure your money is growing.
    Thanks again for the article. I enjoy your work.

    • Robb Engen on November 22, 2023 at 11:46 am

      Hi Philip, thanks for the kind words.

      It is indeed a delicate balance for retirees living off their portfolio. Lots of good evidence suggests maintaining a constant asset allocation is still going to lead to the best outcomes, versus holding a cash wedge of 1-3 years’ worth of spending.

      But psychologically it’s nice to have a source of non-risky assets to draw from when markets are down. I’ve even seen an argument to draw on a line of credit for a year instead of drawing on a portfolio that’s down significantly. This can allow your investments the time to recover and get you back in line with that longer term average.

      • James R on November 25, 2023 at 2:21 pm

        Yeah, I agree with this. I’ve seen other studies that suggest also investing your emergency fund for similar reasons – that tying up large lump sums for safety is often less useful than investing them.

        I get the cash wedge and might build 3-6 months of cash by strategically turning of the DRIP ahead of retirement.

  7. Neil Bouvier on November 23, 2023 at 8:10 am

    Great article Robb.

Leave a Comment





Join More Than 10,000 Subscribers!

Sign up now and get our free e-Book- Financial Management by the Decade - plus new financial tips and money stories delivered to your inbox every week.