Retirement Planning – What’s Your Hurdle Rate

In over 18 years in the financial services industry, I continually see biases and mistakes that people make in their financial planning (or lack of planning). These biases can lead to less than optimal investment decisions (in many cases buying on greed and selling on fear – typically at the worst times). When coupled with making bad financial/money decisions near or in retirement, the result can be catastrophic to long-term financial success.

I wanted to start by listing some of the biggest mistakes people make in retirement (I won’t go into all of them in detail today, but will cover them in more detail in future posts):

1. Not knowing or starting with their long-term objectives, but rather making decisions on the fly (shooting from the hip).
2. Not taking into consideration “longevity risk”. What if they live longer than expected?
3. Not considering income taxes, estate taxes and inflation.
4. Focusing on a “Retirement Number”, as seen in many commercials lately. Having a target dollar, such as $1 million, as their goal without knowing whether that is an appropriate target given the other factors listed here.
5. Focusing on a benchmark rate of return (such as the S&P 500) to determine how much they need to earn on their savings and investments to reach their goals. I address this in an article I wrote titled, “3 Things Most Financial Planners Do Wrong.”
6. Not truly knowing what they will need over the long run in terms of their living expenses and healthcare expenses. In my experience, most people do not even know what they are spending now.
7. How and where to best accumulate wealth, such as in pre-tax, after-tax, or tax-free accounts, given their situation.
8. Not knowing when to start lifetime benefits such as Pensions and Social Security. Another topic to consider would be whether, if available, they should take their company pensions as a “lump-sum” or a lifetime “annuity” payout.
9. Not knowing how to allocate their portfolio – how much in stocks, bonds, commodities, real estate, cash, etc. given their personal planning needs.
10. Not knowing which assets to use first in retirement – where should you pull your “retirement paycheck”? Should it be from IRAs, after-tax accounts, pensions, etc.

When creating a comprehensive financial plan, you and your financial advisor need to address these questions to better understand the issues and answers that are specific to you. I spend considerable time on these issues (especially when clients are in or near retirement) to help make sure that my clients have a clearer roadmap to financial success and help them avoid biases and mistakes.

A financial plan should take into account:

1. The long-term objectives for you and your family,
2. Current and future spending needs (and also anticipate unexpected spending, “rainy day” expenses, such as health care or long-term care needs),
3. Your current assets,
4. How much you can save given your current and projected income and expenses,
5. What your target or expected rate of return is (I would have you consider a rate 1-2% above inflation as a starting point),
6. Family history on life expectancy (will you outlive your money?), and
7. Taxes and Inflation.

When working with clients, we use this information in our financial planning software to look at various “what-if” scenarios to determine customized targets as to when a client may be able to retire given their current and anticipated resources and their long-term goals. We then stress test these scenarios (using Monte-Carlo simulations) to calculate the family “Hurdle Rate” – a minimum rate of return that a client needs to achieve their goals. This is a personalized “benchmark” that has nothing to do directly with what the stock or bond markets have returned in the past or will return in the future.

Our belief is that if a client knows their hurdle rate, they can make better decisions with fewer biases or planning errors.

Two Examples:

First Example: if you believe you need to be very aggressive, such as having all of your retirement funds in stocks, to achieve your goals, yet your hurdle rate is only 3% return, why would you take so much risk (if you recall, the stock market was down over 37% in 2008)?

Second Example: If you want to retire at age 60, but based on your long-term financial objectives, you would need a 12% hurdle rate of return (much higher than the market has provided in any rolling 20 year term), then you may have to work and save longer.

Knowing your hurdle rate allows you to ride out market corrections without getting overly greedy when the markets are bullish or overly pessimistic when markets correct. Better behavior and prudent planning can help you stop guessing, stop listening to the talking heads on the financial news that makes you concerned about day to day market movements and overall worry less. Hopefully your financial plan will give you the confidence to make more prudent decisions while overcoming your biases.

Bottom line, your goal should be to become an aggressive saver in line with your goals while being a conservative investor. Why should you always be trying to hit home runs when “singles” over the long run is what “wins games?”

IMPORTANT DISCLOSURES

Financial Planning and Investment Advice offered through STA Wealth Management (STA), a registered investment advisor.

STA does not provide tax or legal advice and the information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters or legal issues, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.

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