Problems using “Averages” in Financial Plans

Posted by Gary Abely, CFP®, AIF®, CPA

If someone suggested to you that, on average, you will feel fine if you place one hand on a fire and another on dry ice, you would instinctively know to raise your antenna when listening to this individual.

Yet, many financial planners use averages when discussing healthcare expenditures in retirement, life expectancy, inflation and past investment performance, as if averages tell the entire story.  Using averages can lead to misleading planning results and, at worst, cause someone to outlive their money in retirement.

Let’s start with life expectancy.  U.S. life expectancy ranks 26th in the world, according to a recent OECD report (OECD – Organization for Economic Cooperation and Development).  Most of us know that as Americans we can expect to live until our late 70’s (men), or early 80’s (women), on average.  We also know that life expectancy can vary significantly by the state we live in, our race and gender.  “Average” life expectancy takes into consideration premature deaths due to auto accidents and drug overdoses, something less likely to occur in our retirement years when compared to our teenage years.  When creating a financial plan, it is more important to discuss with clients the probability of living into one’s 90’s vs. averages.  Currently, a couple both aged 65 has about a 1 in 3 chance of at least one spouse living to age 95.  Today, many of us could be retired for almost as long as our working years. So, while we are likely to live only 15 to 20 years in retirement, it is prudent to plan for 30 years.

Inflation modeling using averages can also be dangerous.  Recently, inflation has averaged close to 2%.  Many financial planners model between 2-3% inflation in their client’s financial plans.  This range appears to make since given Inflation has averaged a little over 3% since 1913.  However, with this average it is important to remember that we have had three decades where inflation has averaged greater than 5%.  As they say, timing is everything.  Financial plans assumptions must change as circumstances dictate.

Recently, AARP announced that retirees are likely to spend, on average, approximately $220,000 in retirement on healthcare costs (not including long-term care costs).  While this data is useful for budgeting for healthcare expenditures, many of us who take expensive medications will find this amount woefully short.  Once again, averages don’t tell the full story.

Finally, an initial visit to most financial planners will involve a discussion of “typical” or “average” long-term rates of return on various asset classes.  Not uncommon, the conversation goes something like, “The U.S. stock market has averaged 9% over past eighty years”.  I would argue that unless you retire after completing high school this long-term average may not be applicable.  Past performance, even over long periods, may not repeat.  For example, how many companies did Ford compete with eighty years ago for its share of U.S. auto market.  Today?  How much healthcare costs go into a Ford vs. a South Korean counterpart?  How often is a Japanese auto manufacturer sued by its employees for age discrimination, overtime, pay inequality, working conditions, etc.?  Bottom line:  We won’t know if recent stock market average returns closer to 6% (past 10 years) is a new norm or a departure from the long-term average.  My advice:  Model conservative returns in your financial plan and celebrate when you outperform your goal.  Also, don’t try the fire and ice theory of averages at home.

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