“We looked at our account balances, and based on our back-of-the envelope thinking, it looks like we’re fine.” Amy said with not a small amount of pride.
“That’s great. Tell me how you came up with your results,” I responded.
“We added up all our accounts and figured with a 6% return we should be able to get by just fine in retirement.”
“That’s wonderful,” I replied. “So tell me, how are you going to guarantee 6% every single year?”
The question hung in the air like a rain-laden cloud. The storm was on the horizon, only Amy and Patrick didn’t know it. Clearly, this question was not one they had considered.
We humans tend to be great at simplifying even the most complex of problems; it’s a habit we fall into in order to have our problems make sense in our universe. In Amy and Patrick’s case, their desire to find a satisfying answer led them to make careless assumptions or omit important facts that significantly impact the outcome.
Many people engage in back-of-the-envelope thinking without taking some crucial steps and examine important facts. Here’s how:
- Beginning retirement without a clear idea of what retirement actually looks like in terms of numbers. Which lifestyle activities, costs, and issues need to be factored into a spending plan that will not leave you outliving your resources?
- Assuming an annual return each year, without taking into account the normal fluctuations in the markets. Just because something exists today does not mean it will exist tomorrow.
- Not understanding the difference between retirement funds and non-retirement accounts. Remember, your taxes and cash flow are impacted by spend-down.
- Not having an appropriate amount of liquidity to protect yourself from unexpected expenses and market volatility. Nobody can predict the future, but you can prepare for what might happen.
- Not accounting for unexpected occurrences—medical, family, legal, changes in tax laws, death, divorce, disability, etc. How do these changes affect your spending plan and savings?
- Failing to consider your living situation and whether it is appropriate for your needs as you age.
- Being overly optimistic – which is unrealistic. The “best-case scenario” rarely happens.
When it comes to important life transitions like retirement, perspective, judgment and objectivity are vital to prevent mistakes that can lead to disaster. Before you rely on back-of-the-envelope planning, consider Amy and Patrick and their near disaster of arriving at conclusions based on incomplete information, lack of full knowledge and understanding and inappropriate assumptions.
To avoid going down this path yourself, try the following instead:
- Begin by questioning your level of knowledge. Swallow your pride. Just because you believe it’s true, doesn’t make it so. Validate your beliefs with facts. Know what you don’t know!
- Never plan for the best-case scenario; only the worst-case scenario is important. Be realistic.
- As Stephen Covey says, “Begin with the end in mind.” Devote the time to considering your life in the next stage. What will make it meaningful, valuable, and successful? Think of it as planning from the bottom up.
- Enlist the help of experts who can guide you.
Leave the back of the envelope for your grocery list or to do’s, not for your financial planning. It’s too important.