Planning for Retirement—Preparing a Cash Flow Forecast

A retirement cash flow forecast is a tool used by advisors that can help you assess your plans for retirement and to determine whether adjustments are needed to help you achieve your goals. The idea behind the analysis is to attempt to project the impact of several components that will materially affect your retirement.

These components would include; an estimated rate of return on your portfolio, an estimate of your annual living expenses, sources of income (like social security, pensions, and deferred wages), and any possible capital expenses. Understanding the assumptions that go into this forecast can improve your understanding of the results and its value to you.

Many people are often focused on the number of years until retirement but do not realize that it is the number of years in retirement that is more important for a cash flow forecast. Average U.S. life expectancy for a 65-year-old male/female today is to age 84.3/86.6(1). For the affluent, life expectancy is even longer(2). For a cash flow forecast, you should plan on living longer than average—we often use the life expectancy of age 95 in our forecasts and sometimes age 100. For a 55-year-old client today who wants to retire in five years at age 60, that means a 40-45 year forecast. A long-term forecast, while a helpful guide, is inherently less predictive than a short-term forecast due to the increased uncertainty.

In addition to the length of the forecast, the timing of the portfolio returns can also impact the results. A forecast that assumes a constant investment return over many years can hide the risk inherent in your retirement portfolio and its ability to last as long as you do.  Very simply, if markets are down in the years leading up to and early into retirement, there will be pressure on the success of a retirement plan. While adjustments can be made in the form of delaying retirement, reducing spending, or taking more risk with the portfolio, these are often unwelcome steps most investors would like to avoid.

Conversely, if markets are up in the years leading up to and early into retirement, it will provide more cushion for achieving retirement goals. To illustrate this, a statistical simulation tool called a Monte Carlo analysis is often used to demonstrate the possible portfolio outcomes and the probability of retirement success. Hundreds or even thousands of possible portfolio sequence of returns are simulated to predict the chances of retirement success or failure.

What Assets to Designate

Upon death, assets are passed to survivors in three ways;

  1. beneficiary designation (i.e IRA’s or insurance policies),
  2. by operation of law (i.e joint ownership), and 3) through probate (your Will).

If you’ve ever had a Will drafted, you may be familiar with the terms “probate” and “non-probate.” Probate assets are assets that are owned individually and must pass through the court (through the interpretation of an executed Will or through intestate succession to a living beneficiary).  So essentially, a Will informs the court system how to distribute assets held solely in your name or your share of a joint asset (tenants in common), such as a checking/savings account, your personal property, or an investment account, directly to the person or persons you’ve named in the document.  You may think to yourself, “great, I’ve already executed a Will naming my spouse/best friend/child/charity as the recipient of my estate; mission accomplished.”  However, you’d be celebrating a little early as you may have forgotten about your non-probate assets.

Non-probate assets are a little easier to recognize, as they require the designation of a beneficiary when you open the account.  At death, these assets will pass directly to the beneficiary of the account, superseding anything directed in your will. Simple enough, right?  So I’ll ask again, what kind of assets pass through beneficiary designation?  Retirement plans, like your 401(k), 403(b) pension, and defined benefit plans, individual retirement accounts (IRAs) or any variation of IRAs (SEP, Roth, Rollover, Inherited), and life insurance policies pass through a beneficiary designation. For simplicity’s sake, let’s focus on your retirement assets (employer-sponsored plans, IRAs, etc.).

When was the last time you logged into your retirement account online and checked your beneficiary designation?  Was it when you started your job?  When you got married? When you had children?  For many of us, myself included, it has been far too long since we’ve revisited our beneficiary designations and how they fit into our current estate plans.

Like any good tool, Monte Carlo forecasts come with some nuances that should be understood to better utilize the results of the forecast. The first, as noted above, is that longer forecast periods are inherently less certain than shorter periods. Second, forecasted risk and return levels—which have a powerful impact on results—may vary depending on when the forecast was made. For example, the 2017 JPMorgan current long-term forecast for US Large Cap returns is 6.25% (this represents an expected return of the asset class over the next 10+ years).

Just three years ago, however, the forecast was 7.50%. This seemingly insignificant differential compounded over 40 years will have a major impact on the results. As an illustration, $100,000 invested today at 7.50% compounded annually for 40 years would give you $1.8 million. The same investment compounded at 6.25% gives you only $1.1 million. Finally, a forecast using an asset allocation for a 55-year-old that assumes the same static allocation until death—an unlikely course of action—may be misleading.

The reality is that a more conservative portfolio—lower risk and return—would be implemented at older ages and a higher risk and return would be implemented during the earning years.  The lack of dynamic portfolio modeling is a major drawback of some Monte Carlo analyses. A forecast that allows you to change allocations and/or returns is more useful than one that does not.

On the other side of the retirement equation, spending patterns also have a major impact on the success or failure of a retirement plan. You may assume a certain expense level early in retirement with a major “step-down” at older ages due to more limited mobility (less travel). While this may occur, it would be more conservative to assume a minor step-down (or no step-down at all) at older ages due to increased health and home-care costs. Breaking spending into categories such as needs, wants and luxuries can also help prioritize spending and make it easier to be flexible and adjust as needed. And don’t forget inflation!

Ideally, a retirement cash flow forecast should be prepared no later than five to ten years prior to your desired retirement date. Properly done and updated annually, it will help track progress toward meeting your retirement goals.  Understanding the key assumptions in the forecast will also increase your confidence in the results.

*Social Security Administration

*“The Association Between Income and Life Expectancy in the United States, 2001-2014”, The Journal of the American Medical Association

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About the Author:

Richard Freeman is a Senior Director, Wealth Advisor at Round Table Wealth Management. Read Richard's Biography >