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5 Scary Assumptions Investors Are Making

Assuming rosy return projections, persistently mild inflation, or an average life expectancy can trip up a retirement plan, says Morningstar's Christine Benz.

Jason Stipp: I'm Jason Stipp for Morningstar and welcome to The Friday Five. Sitting in this week for Jeremy Glaser is Christine Benz, our director of personal finance, with five scary assumptions that some investors are making.

Christine, thanks for joining me.

Christine Benz: Jason it's great to be here.

Stipp: We are approaching Halloween. You brought a scary-themed Friday Five: Certain assumptions that folks probably shouldn't be making if they want to have more treats than tricks in retirement.

Let's start with the first frightening assumption--being overly optimistic. Aside from a few bumps in recent times, it's been pretty easy for investors to be optimistic.

Benz: My concern is that today a lot of investors are taking near-term market returns and extrapolating them forward, assuming that this very strong equity market that we've had--really since 2009 with just a few interruptions here and there--will be persistent.

We have had great market returns over the past three and five years, something like 16% on an annualized basis over the past three years, and 14% over the past five years. But when you look at sober forecasters of market returns, what they are projecting, they are much less sanguine. I recently talked to Jack Bogle, for example, the founder of Vanguard. He was forecasting 10-year equity returns in the neighborhood of 4%, which is quite muted, even relative to his forecasts in the past. GMO, Grantham Mayo van Otterloo, are kind of a notable bear, but at mid-year they were forecasting a seven-year market forecast for equities in negative territory once you factor in inflation.

I think it's important to keep those in mind. Remember that although over long periods of time, the equity market has beaten other asset classes, you do need to be careful about the return projections that you bake into your own retirement-planning assumptions.

Stipp: 14%-15% is obviously way too high for a long-term projection. Maybe I'm not as pessimistic as negative returns, or 2% or 3% or 4% returns. But what if I do want to be more realistic? What does that mean for how I should plan around those lower expectations.

Benz: Unfortunately, it's not a sexy answer. If you are using what I think are reasonable return forecasts of, say, 4% or 5% non-inflation-adjusted returns, in many cases that will mean, when you run the numbers, you're going to have to kick up your savings rate, and that's not fun for anyone. But here I think it's better to be safe than sorry. It's better to save too much and have the market surprise on the upside, than encounter a negative shortfall in your retirement savings when you don't have much time to make up for it.

Stipp: Scary assumption number two is thinking that you can hold a very equity-heavy portfolio and expect the upward trajectory that we've seen in the last several years to continue.

Benz: One major risk for investors today is complacency. It's related to the first point. We've had a very strong equity market. I think perhaps many investors are downplaying the risks of big losses in their portfolios. I'm even talking to retirees who tell me that they have 100% equity exposure currently. I think we've all become comfortable with that risk-taking.

Investors are forgetting how bad it felt back in the financial crisis to see our portfolios literally shrivel in half if we had a lot of stocks. And it's not just the psychological trauma, the emotional trauma, that we undergo when our portfolios lose a lot, but there is also a real chance that if you lose a lot as you are approaching retirement, you will have to change your plans. If your portfolio is coming up short, if you encounter that equity market shock and your portfolio is mostly equities, you may have to shuffle things around and delay your retirement date to make your retirement plan work.

Stipp: What to do to overcome this kind of frightening assumption will vary depending on where you are in your investing lifetime.

Benz: That's an important point. Younger investors--certainly those who have, say, a 20-year time horizon or longer--they should be primarily invested in stocks. But people with a time horizon of 15 years or fewer to retirement do need to start battening down the hatches with at least a portion of their portfolio, where they are parking greater and greater shares of that portfolio in high-quality fixed-income investments, maybe a little bit of cash. You don't have to do a full-on bucket approach if you're not yet retired. But I think it does make sense to start segregating some safer assets from the risky equity-heavy piece of your portfolio.

Stipp: Frightening assumption number three is that inflation won't be taking a bite out of returns. This is something that folks haven't had to really worry about, at least in broad terms in recent years. But what about inflation going forward? Is that something that we should really be assuming will come back?

Benz: I don't think it's safe to assume that inflation will stay benign forever. Certainly we have seen pretty benign inflation in the past few years. Really, over the past decade inflation has been well under control.

But when you look at one of the main factors that's been driving down inflation lately, it's been energy prices. When judging how big a deal inflation is for you, you need to think about your own consumption basket--what you're spending money on. If you are someone who doesn't drive a lot, who doesn't have large fuel consumption, you will benefit less from those declining energy prices than someone who is a heavier driver. By the same token, if you are someone who is a heavy user of health care--as many retirees are--you are probably experiencing greater inflation than the general population.

Think about that customized inflation rate, and then when you are managing your portfolio, especially if you are a senior living on a fixed income, make sure that you're making adjustments to ensure that rising costs don't eat alive the stream of income you are taking from your portfolio.

This means that "safe" securities, when you're looking at returns of 2% or even less, they are not so safe on an inflation-adjusted basis. It also means that if you are drawing money out of nominal bonds, non-inflation-adjusted bonds, you want to add a little bit of inflation protection to that portion of your portfolio.

We've talked about how Treasury inflation-protected securities certainly haven't done much for investors over the past several years, but I think they are a nice addition to retiree toolkits. Bank-loan investments would be another idea, another way to pick up some inflation protection for your bond portfolio. They shouldn't be your whole bond portfolio, but I think they are a decent addition with nice inflation-fighting characteristics.

Stipp: Another scary assumption, maybe scary for a few reasons, is that you will have a normal life expectancy. I think we'd all like to think that we will live longer, but you also have to plan to live longer.

Benz: If you look at the actuarial tables, or if you look at the Social Security Administration's website, you can see that the average life expectancy for a male today in the U.S. who reaches age 65 is 84 years. A woman who reaches age 65 will, on average, make it to 87 years. But it is a mistake to assume that you definitely will have an average life expectancy. Some people will have shorter life expectancies. Some people will have longer.

If you're the type of person where your health has been great, you've got a lot of people with longevity in your family, you probably do want to go beyond those average life expectancies and think about a longer-than-average life expectancy. If you are retiring at age 65, and you've got those good positive characteristics on your side, you probably want to bake in a 25-year or even a 30-year time horizon, because there is some probability that folks who are 65 today will make it to 90 or 95 and beyond. So think about those chances and position your portfolio accordingly.

Stipp: Also, if you have a spouse, there is a much greater chance that one or the other will be living longer.

Benz: That's right.

Stipp: Last frightening assumption involves funds you might be paying up a little bit more for because they've been great performers. Thinking that they are going to keep being great performers and worth that extra expense is not a great assumption to make.

Benz: It isn't, certainly when we look at our data. I often evangelize about the importance of costs, as do many of us here at Morningstar, and invariably a hand will shoot up and someone will say, "What about this find? It's been a great performer. I'm putting my money there, even if it has a 2% expense ratio."

When we look at our data, at the factors that are most predictive of good performance going forward, low costs are a much better predictor than is great past performance. It's just like that little disclaimer that's on all the fund literature: "Past performance is no guarantee of future results."

It's really important to bear in mind when you are making those selections, even if a fund has a great track record, if it's hobbled by very high costs, that's going to be a headwind that it may not be able to overcome. I would say this is particularly important in the realm of investments where the range of returns is very narrow. Think about a category like high-quality intermediate-term bonds, for example. The funds are bunched tightly together in terms of their returns. There are only a few differentiators that funds can use--expenses would be one of them. If a manager is able to overcome high expenses, he or she is probably taking some extra risk in that portfolio to generate above-average returns. So sometimes that high-cost portfolio has risks that come home to roost later on.

Stipp: Christine, thanks for helping us avoid these potential pitfalls today.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.