Retirement Planning: What’s Your Hurdle Rate?

In over 20 years in the financial services industry, I have consistently seen biases and mistakes people make in their financial planning (or lack of planning). These biases can lead to less-than-optimal investment decisions (in many cases buying in greed and selling in fear, typically at the worst times). When coupled with making bad financial decisions near or in retirement, the result can be catastrophic to long-term financial success.

Some of the Biggest Retirement Mistakes

I wanted to start by listing some of the biggest mistakes people make in retirement (I won’t go into all of them in detail today, but will cover them in more detail in future posts):

  1. Not knowing or starting with their long-term objectives, but rather making decisions on the fly (shooting from the hip).
  2. Not taking into consideration longevity risk. What if they live longer than expected? (For related reading, see: How to Plan for the Longevity Risk in Retirement.)
  3. Not considering income taxes, estate taxes and inflation.
  4. Focusing on a retirement number,” as seen in many commercials lately. Having a target dollar amount, such as $1 million, as their goal without knowing whether that is an appropriate target given the other factors listed here.
  5. Focusing on a benchmark rate of return (such as the S&P 500) to determine how much they need to earn on their savings and investments to reach their goals. 
  6. Not truly knowing what they will need over the long run in terms of their living expenses and healthcare expenses. In my experience, most people do not even know what they are spending now. (For related reading, see: Planning for Healthcare Costs in Retirement.)
  7. How and where to best accumulate wealth, such as in pre-tax, after-tax, or tax-free accounts, given their situation.
  8. Not knowing when to start lifetime benefits such as pensions and Social Security. Another topic to consider would be whether, if available, they should take their company pensions as a lump-sum or a lifetime “annuity" payout.
  9. Not knowing how to allocate their portfolio—how much to invest in stocks, bonds, commodities, real estate, cash, etc. given their personal planning needs.
  10. Not knowing which assets to use first in retirement—where they should pull their retirement income from first. Should it be from IRAs, after-tax accounts, pensions, etc. (For related reading, see: Strategies for Withdrawing Retirement Income.)

When creating a comprehensive financial plan, you and your financial advisor need to address these questions to better understand the issues and answers that are specific to you. 

A financial plan should take into account:

  1. The long-term objectives for you and your family
  2. Current and future spending needs (and also anticipate unexpected spending, such as long-term care needs)
  3. Your current assets
  4. How much you can save given your current and projected income and expenses 
  5. What your target or expected rate of return is (I would have you consider a rate 1-2% above inflation as a starting point)
  6. Family history of life expectancy (will you outlive your money?)
  7. Taxes and inflation

Use this information to look at various “what-if” scenarios and determine when you may be able to retire given your current and anticipated resources and long-term goals. Then stress-test these scenarios to calculate the family hurdle rate, a minimum rate of return needed to achieve your goals. This is a personalized benchmark that has nothing to do directly with what the stock or bond markets have returned in the past or will return in the future.

If you know your hurdle rate, you can make better decisions with fewer biases or planning errors.

Two Examples of Using Your Hurdle Rate

  1. If you believe you need to be very aggressive, such as having all of your retirement funds in stocks, to achieve your goals, yet your hurdle rate is only 3%, why would you take so much risk (if you recall, the stock market was down over 37% in 2008)?
  2. If you want to retire at age 60, but based on your long-term financial objectives you would need a 12% hurdle rate of return (much higher than the market has provided in any rolling 20-year term), then you may have to work and save longer.

Knowing your hurdle rate allows you to ride out market corrections without getting overly greedy when the markets are bullish or overly pessimistic when markets correct. Better behavior and prudent planning can help you stop guessing, stop listening to the talking heads on the financial news that makes you concerned about day-to-day market movements, and overall worry less. Hopefully your financial plan will give you the confidence to make more prudent decisions while overcoming your biases.

Bottom line, your goal should be to become an aggressive saver in line with your goals while being a conservative investor. Why should you always be trying to hit home runs when singles over the long run is what wins games?

(For related reading, see: Saving for Retirement: The Quest for Success.)