By Kyle Morgan
Learn more about Kyle at NerdWallet’s Ask an Advisor
Analyzing the available data is an important part of making financial decisions, but many people don’t understand the critical role assumptions play, especially when it comes to retirement planning.
As you craft or update your retirement plan, here are three often-overlooked financial planning assumptions you must make — and how to make sure your assumptions are as useful and accurate as possible.1. Assuming your life expectancy
Outliving your money is one of the most common and significant fears people have about their retirement. To know how much money you need to save for retirement, you need to have a pretty good idea of how many years you’ll be drawing on your retirement savings.
No one knows exactly when his or hernumber will be up, but you can use available data as a starting point for your educated guess. According to the Social Security Administration, a 65-year-old man can expect to live nearly 20 more years, to roughly 84. A woman turning 65 today has a longer life expectancy, to 86.6.
However, about 1out of every 4 current 65-year-olds will live past 90, and 1 in 10 will make it past 95. What’s more, advances in medicine and technology continue to steadily increase the average life expectancy.
What will you do if you plan to retire at 65 and live to 85 but hang in there much longer? It may seem sensible to use life expectancy averages for financial planning, but outliving your plan can be financially devastating.
Many people are uncomfortable talking about health and death, but it’s important to understand the implications of living longer than you planned for, especially during years when you’re likely to need more medical care. Talk to your financial planner about your current health and family history and whether traditional life-expectancy tables are the best option for making your assumptions. You may find it makes sense for you to add 10, 15 or even more years to your assumption.2. Assuming you’llget contingent assets
When you’re planning for retirement, there are real assets — money you know you’ll have, like your 401(k) or individual retirement account— and there are contingent assets, money youthinkyou might get. Contingent assets, such as unvested stock options, an expected inheritance or a large year-end bonus, may provide a future economic benefit, but they’re not guaranteed.
Incorporating contingent assets into your retirement plan is one assumption you don’t want to make. A contingent asset doesn’t belong to you and may never land in your bank account. What happens if you’re counting on that asset as part of your retirement income and you never receive it? You’ll be left with a shortfall that may be hard, if not impossible, to make up.
The best approach for contingent assets is to track them but not to count on them as partof your retirement plan until you have the money in hand.3. Assuming inflation’s impact
While it’s a sure bet that prices of typical needs like housing, food and transportation won’t decrease, it’s important to project how much more they’re likely to cost when you retire. The difference between what those things cost now and what they’ll cost when you retire isinflation.
The Consumer Price Index is the most common measure of inflation. The government sets the CPI, consideringthe prices of hundreds of items in more than 200 categories to arrive at thefigure. Failing toproperly account for inflation can spell disaster for your retirement planning.
Let’s say you have a goal to buy a beach house when you retire. Currently, beachfront houses in your target area are going for $1.5 million. You create a savings plan to reach$1.5 million by the time you retire in 20 years. Every year, you sock away cash to meet your goal.
Fast forward 20 years. You retire, you’ve saved the $1.5 million, and you can’t wait to run out and buy your dream home. Unfortunately, prices of the houses you fell in love with 20 years ago have grown3.5% annually, and the $1.5 million house you loved 20 years ago now costs almost $3 million.
When making assumptions about inflation, it’s best to err high. We recommend an assumed inflation rate of at least 3.5% for personal living expenses like groceries, utilities and gasoline. Higher education and medical costs are rising even faster; assumean inflation rate of 5% to 7% annually to help retain your money’s purchasing power after retirement.
Overall, it makes sense to be conservative with financial planning assumptions and adjustthe plan as needed over time. The assumptions highlighted here are often overlooked but are just as important to factor in as the more obvious assumptions, such as the rate of return on your investment portfolio.
Your financial planner can help you establish baseline assumptions and decide how to adjust them to maximize the success of your plan and ensure you’re ready for retirement when the time comes.
A previous version of this article misstated the current age for the 1 of 4 people who will live past 90 and the 1 of 10 who will live past 95. This article has been corrected.
The article Key Assumptions That Can Make or Break Your Financial Planning originally appeared on NerdWallet.