A financial retirement plan covers a lot of ground, and the more variables that are included the more reliable the plan will be. But you can't forget that what you are ultimately doing is trying to forecast the future, which we all know is an exercise in frustration. That doesn't mean that it isn't worthwhile - it's important to to be as prepared as possible so that you can take steps to protect yourself - you just need to keep in mind that things will likely not turn out as you expect. As the saying goes, "Hope for the best, but plan for the worst".
In terms of a financial plan, this means that you should enter all information as realistically and conservatively as possible. But that's just the beginning. Just because your house has four walls and a roof doesn't mean that it is well built. Likewise, a financial plan also needs a little extra work to make sure that it is solid. Once you've entered what you expect to happen, then you need to stress test your plan to see what might happen if things turn out differently. This is often done by increasing expenses and/or lowering income and/or lowering investment returns, and/or increasing the rate of inflation beyond what is expected. All of these variables are integral to your plan so even small changes to only one of them can have a huge impact on your net result. For example, during a 25 year retirement period:
• Increasing the inflation rate by even .25% (on $65,000 in annual expenses) could cost an extra $100,000.
• Assuming a $1M starting balance, using a 5% annual investment return instead of 6% lowers total returns by $1M.
• Lowering your expenses by 10% (from $65,000 to $59,000 annually) could save over $220,000.
It's clear that small changes can have large impacts. For married couples, one variable that is often ignored is what happens if one spouse dies earlier than expected. It's common for financial plans to calculate results through age 90, 95, or even 100, but what would happen if one spouse died at a younger age? There can be a wide range of financial impacts, but two consequences are certain:
• There will be a loss of Social Security income since the surviving spouse will only receive one benefit instead of two.
They will usually get to keep the larger of the couples two benefits, but it will still present a loss of income.
• The tax filing status of the surviving spouse will change from Married - Filing Jointly to Single.
This reduces their standard tax deduction, and usually increases their marginal tax rate. Even if they have no income other than Social Security, it can affect the tax liability on RMD's.
How much of a difference could these two changes make? To keep things simple, we will assume that both spouses are age 65, have $1M in total savings, earning 5%, and both start collecting Social Security at age 65, with each receiving $2,000/month in benefits. They have no other income, and have $65,000/year in expenses, with a 3.0% inflation rate. RMD's are accounted for.
If they both live until age 90, they will have just over $1,260,000 in savings.
If one spouse dies at age 85, the surviving spouse will have just over $1,040,000 at age 90, or 17.5% less.
If one spouse dies at age 80, the surviving spouse will have just over $790,000 at age 90, or 37% less.
If one spouse dies at age 75, the surviving spouse will have just over $515,000 at age 90, or 59% less.
While the financial result is still positive in each case, it is clear that an earlier than expected death significantly reduced the original plan result by as much as 59%.
This was a simplistic example and a multitude of other variables could be introduced to change the result, positively or negatively. This is exactly why you need to stress test your financial plan. Many people think about modeling different inflation rates, or changes in income, but an untimely death is rarely planned on even though it could result in a serious loss of financial security. It may be unpleasant to consider such a tragic event, but if it would present an unexpected financial hardship for the surviving spouse it is best to be aware of it in advance so that you can take steps to mitigate the impact. After all, the whole point of a financial plan is to make sure that you won't be caught off guard, and will,
in fact, be well prepared, especially at the worst possible moment.