By: Martin M. Shenkman, CPA, MBA, JD
You're planning your retirement and estate. Your financial planner develops a budget and a plan. The budget results will determine cash flow needs upon which investment strategies may be based. These strategies then need to be coordinated with your overall estate, asset protection, and other planning. Too often, projections are flawed and lead to inappropriate product sales, a false sense of security, or an overly simplistic investment plan. Many investors are overwhelmed by 100+ page computer generated plans. The volume of pages and charts can give the calculations an appearance of reliability:
Your budget reflects anticipated future expenses, for which your planners then determine the best way to generate adequate cash flows (e.g., an asset allocation model that reaches your goals while minimizing investment risk). Expense projections may use your current expenses as an assumption. Will your future expenditures mimic current outlays? If not, projecting historical costs might be meaningless. Are you planning to downsize your current home, or instead to purchase a vacation home? The swing in annual costs can be huge. You must evaluate your future expenses or your planning will be based on misleading assumptions.
Inflation of your expenses has to be considered. Many projections assume a 3% inflation of expenditures. 3% may be a reasonable historical average for inflation, but is it sufficient for your particular situation? If your retirement expenditures will focus on medical expenses, luxury travel, and grandchildren's tuition, not only might these expenditure patterns differ significantly from what you've spent in the past, but they might inflate at far faster rates than the market basket of goods on which the average 3% data is based. A 1% difference in inflation rates over a 20+ year retirement can wreak havoc in your plan. Evaluate the rate. Stress test the plan. What if your expenditures inflate at 5% instead of 3%? If you invest solely in muni-bonds, CDs, and other income investments for safety, stress test your projected cash flow versus realistic costs. Including inflation may undermine your expectations.
Did you budget for gifts? You may wish, during your retirement, to step up gift programs to your family. This is not only done to address estate tax, but to help children at ages when they are buying houses or launching businesses, etc. Too often these potentially significant transfers are ignored in the projections, and there is not enough cash flow to undertake the new responsibility.
Most people tend to underestimate their life expectancy when planning for their financial issues in retirement (a lot of people out-live their life expectancy), but overestimate their life expectancy when putting off estate planning decisions. Get realistic about both. Life expectancy is getting higher, so maybe the age of retirement should too.
Every investor knows compound interest is the 8th wonder of the world. But when the above issues compound over the potential decades of your future retirement the number swings are potentially devastating. Caution now may mean a pinch in your budget. Unrealistic assumptions now might mean selling your home in 15-20 years to pay for living expenses. Make sure you take all potential expenditures into careful consideration. The little problems all add up.
Your investment asset allocation plan should, according to many, differentiate between taxable and non-taxable accounts. Tax inefficient assets could be held in non-taxable (retirement) accounts. These might include REITs (high dividends), taxable bonds (high interest), and small cap stocks (high turnover). Tax efficient asset classes could be held in taxable accounts. These might include muni-bonds (tax free interest) and large cap stocks (less turnover). This approach is too simplistic if it ignores the trusts and entities many high net worth investors have. A bypass trust created by your late spouse for your benefit could favor asset classes most likely to appreciate since the growth will be outside your taxable estate. If you use grantor retained annuity trusts (GRATs) to leverage gifts of assets out of your estate, the most volatile asset classes could be held in such trusts since short term GRATs remove the appreciation (upside volatility).
A budget and financial plan can be the foundation for much of your planning. But if they're based on faulty assumptions, your future could be tough.
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