Remember when the coach from the movie Bad News Bears wrote the word “assume” on the chalk board? He then went on to draw two lines – one on each side of the letter “U” to bring our attention to the risk of making assumptions. The lesson has been a major part of my financial planning career as we work to help people understand the risk of competing assumptions. By competing, we mean that some assumptions support outcomes that may appear beneficial to the recipient or the provider and thus have a built in bias toward being higher or lower.
For instance, if you assume a lower inflation rate out into the future then you can presume you need to save less money to replace your standard of living as you age. Furthermore, if you increase your anticipated rate of return you need even less money to retire! With some very zealous assumptions, aided perhaps by a less than well-trained financial planner, we can make the future look rather optimistic or very bleak depending on the story you want to tell. After all it is just assumptions!
It is not just the individuals that have these competing problems however. Entities with defined benefit plans (pensions) including both publicly traded companies and many states have a vested interest in assuming higher rates of returns so they need to put less money into the pension plans each year. General Motors was once touted as the strongest pension in the nation one year and majorly underfunded the next. The actuaries determined retirees were living longer thus more money was needed. Ouch!
Consider the largest pension fund in the United States, CalPERS, the pension fund for California state employees which has $355 billion in its coffers. The investment team has averaged 5.6% returns according to the institution over the last 10 years. In 2017, the Directors voted to reduce the assumed rate of annual return from 7.5% down to 7.375%. Setting aside the assumption has been greater than the result, the minor shift in growth estimates required the state of California to pony up an additional $521 million each year toward the future pension payments.
That is the complexity of competing agendas and financial assumptions. If a pension manager tells the Board of Directors they are lowering the growth rate expectations then the company or state has less profit or money to run the operation and nobody is happy. Similarly, we have had people come to our office with fancy papers telling us another financial advisor told them they could take out much more than they really should. Everyone likes a happier story. We prefer to be more cautious than overly aggressive as nobody knows for certain what inflation, market returns, life expectancy, unknown sudden needs, etc. will actually be 30 years into the future.
Assumptions are necessary – we use them as well – but they can still be very dangerous. Make certain you understand the bias of the creator of the numbers as their assumptions can be competing with your future reality.
Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see our Disclosure page for the full disclaimer.