The trouble with wealth projections

How much is enough? Can I retire now? These are perennial questions that investors seek to answer using projections predicting the future rise and fall of savings. Indeed, you may have created forecasts for your future wealth using Microsoft Excel or one of several online calculators. Many have had projections prepared for them by an adviser, often using brightly coloured graphics illustrating the evolving components of your wealth, income and expenditure. The problem is that all projections are wrong.

Financial wealth projections often provide a false sense of security. In my experience not all investors understand the key assumptions and limitations underlying these forecasts. The big issue is volatility, something the smooth projections don’t account for. Investors relying on simple projections should compare these with actual historical experience. We do that here looking back at more than 120 years of Australian investment market history. To my knowledge, this has not been done before.

(By the way you might be surprised that under current law, end-benefit projections are considered a form of personal advice and cannot be provided other than via a licensed personal financial advisor, or where relief has been provided by ASIC, as it has for online calculators).

A simulated retirement

Figure 1 is a typical projection of one’s savings balance over the years following retirement. Here it is predicted that $1 million invested in an annually rebalanced portfolio, allocated 60% to Australian equities and 40% to bonds, will smoothly and adequately fund 30 years of retirement living. Thirty years is relevant because many people retire at age 60 or 65, and age 90 to 95 provides a safety margin beyond average life expectancy of 82 for men and 85 for women.

This assumes $60,000 (6%) is initially drawn down and that amount is increased with inflation to maintain purchasing power. The calculation is generated assuming this portfolio earns the average rate of return for a portfolio of this construction, which is 9.5% observed for the past 120 years. It also allows 1.5% for fees and taxes, making a net return of 8%. Few people would consider this overly aggressive; indeed, it falls within the band of performance suggested for a balanced fund net of fees on ASIC’s Fido website. An inflation rate of 3.2% is used, the average for this period.

Actual retirement histories

Leaving the world of make-believe and average returns, let’s instead use actual historical year-by-year returns for the Australian share and bond markets, as well as actual inflation figures.

In Figure 2 we show how retirement savings would grow and deplete depending on the year retirement began. Each black line shown is for a funded retirement beginning as early 1885 and every third and fifth year thereafter until lastly for a retirement starting in 1980. There are 40 different retirements shown, none of which match the smooth line projection shown earlier in Figure 1, reproduced here as the red line. Indeed, the powerful message offered in the bizarre looking Figure 2 is that projections provide a false sense of certainty about how investment balances change over time, especially if funding retirement living. Investors even in a balanced fund need to steel themselves for a bumpy ride.

Just over half the projections modelled using historical data fell short of being able to fund the promised 30-year retirement. Some of course provided a better outcome. Obviously a set-and-forget approach to retirement funding won’t work.

The simple average of gross annual returns for years within each line or retirement trajectory varied between 8% and 16%. This is a big difference from the average return. However, this isn’t the only reason for the variation in portfolio longevity.

If we examine retirement histories that share the same average investment return, we can isolate out the effect of that important variable. In Figure 3 we show a subset of historical retirements where the simple average investment return for the years of the funded retirement lifetime is roughly the same: a gross 10% per annum, plus or minus 0.5%. Because variation is still evident, this shows other factors must be contributing to the scatter.

One of these factors is the role of inflation. For the different retirement years selected in Figure 3, the average annual rate of inflation over each period varied from 1.6 to 4.9%. Those who retired in a period of higher average inflation would have seen their money run out earlier than those who enjoyed lower cost pressures. Be thankful when you see the Reserve Bank taking on the fight against inflation.

Inflation isn’t the only factor, however. In Figure 3 we highlight two retirements starting in 1933 and 1951 which share both the same average annual investment return and rate of inflation. Despite this similarity, in the first scenario about 33 years of retirement could be funded, while in the latter case only 17 years could be funded. The difference is due to volatility and timing.

When it comes to retirement funding, smooth steady annual investment returns are much more preferred than periods of up and down. The standard deviation or “bumpiness” of the annual investment returns for those years funding the longer retirement starting in 1933 is a low 7.4%. For the shorter retirement starting in 1951 it was a high 9.9%.

Also the timing of your retirement relative to longer or “secular” investment bull and bear markets and periods of high and low inflation is important. Imagine a retirement made up of two periods, a bull market period with low inflation, and another bear market high inflation period. If you retire first into a high-inflationary, bear market period then your money will run out far sooner than if you instead retire first into a low-inflation, bull market. In the former case your portfolio can’t recover sufficiently to make up for capital depleted.

Couples retiring in 1933 enjoyed stellar equity market investment returns of 29% and 27% in their first two retirement years, when inflation wasn’t a problem. This compares with couples retiring in 1951 around the time of the Korean War who immediately encountered two successive years of negative investment return (–3 and –11% for the ASX) and war-related high inflation.

How to project responsibly

This raises then the question: how can you project responsibly?

One viable answer is to “just say no”. Instead, invest your time ensuring your wealth is properly structured and that your portfolio is designed to weather volatility, fight inflation and achieve a fair reward for risk taken. Use simple conservative rules of thumb for how much your assets might grow and how much is prudent to withdraw.

However, there is great educational benefit from understanding how markets work and gauging the uncertainty that is traded for when seeking higher than cash rates of return.

Things to consider if you make forecasts are:

• Project only for five or 10 years, recognising that significant error creeps into any longer-term projections, making most of them unreliable.
• Round estimates to one or, at most, two single figures. Saying you will have $327,538 in five years implies an unrealistic certainty. Even saying $330,000 is a guess unless your money is in a five-year fixed term deposit.
• Use projections only to explore relative effects, such as changing your draw-down rate, inflation assumptions, fees and taxes and portfolio return. It would be better to “normalise” or change scale from using dollars to a relative 1.0 or 100%.
• Employ a modelling technique that accounts for variability like a “Monte Carlo” simulation, which generates thousands of statistically varied simulations and shows a range of probable outcomes. I have personally used this alongside historical examples to show what real-world investing is like. A problem with this method is that it assumes investment returns are random when in fact favourable and unfavourable years occur more often in sequence.
• Incorporate historical data and do your own back testing. Some say “those who don’t study history are doomed to repeat it” while others remark “if sharemarkets follow history, then librarians would be the richest people in society”.
• Represent information adjusted for purchasing power. Sharemarket returns in the latter part of the 1970s were good, however when adjusted for inflation they weren’t keeping up with long-term real returns.
• Be ultra-conservative in your return assumptions and model with a safety margin – perhaps “wipe off 3%” (borrowing from a road safety campaign).
• Model using a series of lower, medium, higher ranges for returns and inflation. Note, I purposefully don’t recommend using the words “worst” and “best” as markets may invent new versions of these during your lifetime.
• Be sceptical about projections that foretell future balances but do not give due credit to investment approaches designed to mitigate risk at the expense of some upside.
• Don’t forget that 50% live longer than their average life expectancy, and the longer you live, the longer is your life expectancy. In addition to providing a buffer in case your investments underperform, you need a buffer in case you personally outperform.
• If you are a super fund or financial adviser, explain and disclaim. Don’t guarantee any projections and rethink whether providing long-term projections adds value or adds risk to your practice.
• Remember: just like all long-term business, marketing and economic forecasts, all investment projections strictly speaking are wrong.
• And '¦ don't forget about volatility.

Doug Turek, the managing director of personal advisory firm Professional Wealth, speaks and writes on wealth management. This article is based on a submission to ASIC following a recent call for input into the provision of forecasts to superannuation members. Some elements of the article are based on the original work of Canadian analyst Jim Otar.