Most people planning for their retirement will utilize software to develop their retirement plan. They might use a free retirement planning tool they find on the internet or hire a financial planner who uses software to develop their retirement plan. In either case, mistakes are common and very easy to make. Often, mistakes go unnoticed, even by financial planners.
Garbage In Garbage Out
Your plan will only be as good as the assumptions that go into the plan. If you have incorrect assumptions, you will get inaccurate output. You must be extra focused on the assumptions and date inputs when building a retirement plan with software. One incorrect assumption with savings rate, spending rate, tax rate, inflation or returns could result in a plan that fails during your retirement.
Calculations
If you or your financial planner do not understand the calculations going on in the software program, you will be far more likely to miss errors in the output. Learn the calculations in the software program if you want to be successful with retirement planning software. Understand how data input affects data output. If you or your planner do not understand these calculations, you are at a serious disadvantage.
Data Entered in the Wrong Spot
Like tax software, if you enter data in the wrong place, you will get inaccurate output. Investors planning their own retirement frequently make these mistakes.
Risk Tolerance
Many investors do not understand their risk tolerance because they have only a general understanding of investments. Often, their portfolio is invested more aggressively than they realize. If you do not have a strong understanding of investments and asset allocation, then you will not know what to expect for your investments under severe market conditions. The result is that your investment portfolio is likely to be out of alignment with how you really feel about your investments. When you have a retirement plan with a portfolio that is out of alignment with your risk tolerance, your odds of failure increase. The likelihood that you may panic and sell during a crash, increases. Frequently, investors are in this situation and do not know it until it is too late. Your financial plan future returns will be based upon your existing investments, but if those investments are invested more aggressively than your real risk tolerance, you have a problem.
Budget
You need an excellent budget to succeed with a retirement plan. Without a great budget, your plan will be off. Sharpen your pencil and make sure you have an accurate amount for anticipated future living expenses. If your budget is off, the entire plan will be off.
Cost Basis
If you do not enter the correct cost basis for your investments, your tax projections will not be reliable.
Business or Real Estate
Many retirees will need to fund their retirement with the sale of a business or real estate. You need to be diligent and conservative when planning for the future sale of an illiquid asset. What if your business ends up selling for much less than you thought it would? What if the market for your business is poor in the year you try to sell and you cannot find a buyer? What if you lose a key tenant in your real estate property or need to make a large capital contribution, in the year you had planned to sell? You can easily make mistakes when incorporating future liquidity events into retirement planning software. Be extra conservative with these variables.
Sequence of Negative Returns Risk
Not all retirement planning software will incorporate sequence of negative returns event risk. Good planning software will, but often, this risk is ignored by both the financial planner and the client. Your odds of encountering sequence of negative returns in the stock market are 97% for a thirty-year retirement. Meaning that at some point during a thirty-year retirement you are 97% likely to have an event where you have multiple negative return years for stocks. Sequential negative return years can be devastating for retirement portfolios. If you underestimate this risk or ignore it, you are setting yourself up for failure. The biggest risk with sequence of negative returns is how you will react to the losses. Many investors panic and sell out at the bottom. Get comfortable with sequence of negative returns risk and make sure you have an asset allocation strategy you will not abandon when the eventual decline arrives.
Investment Mapping & Classification
When using software to build your retirement plan, you can easily make mistakes by incorrectly classifying investments. For example, labeling growth stocks as value or high yield fixed income as conservative bonds. These mistakes are common. Mistakes with mapping and classification will skew the risk and return metrics of your plan.
Concentration Risk
Not all retirement planning software will properly analyze concentration risk. At a minimum, your plan should incorporate concentration risk and provide an alternative probability of success if you were to have a 100% loss on a concentrated position. Many investors and financial planners ignore this risk when building a software-based retirement plan.
Market Timing
All retirement planning software assumes you will stay fully invested for the duration of your retirement plan. The moment you sell your portfolio in reaction to a crash in the stock market, you have violated the plan assumptions, and your odds of failure go up significantly.
Too Many Accounts
If you are the person who has lots of investment accounts with numerous custodians, your odds of making a mistake increase. Aggregating data from lots of accounts and various custodians raises the odds that you make mistakes with data mapping and classification. Your portfolio risk and return metrics could be off.
Unexpected Expenses
Unexpected expenses are part of life, and they will occur during your retirement. You need to have a plan for them and incorporate unexpected expenses into your retirement plan forecast. If you do not take this important planning step, your odds of failure will increase.
Double Entry
Investors frequently make double entries when entering data into financial planning software. Especially if they have lots of accounts with numerous custodians. Be sure to reconcile your retirement plan projection with all your statements and make sure you did not make any double entries.
Ethan S. Braid, CFA
President
HighPass Asset Management