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Guard Against Optimism When Retirement Scenario Planning

By: Thomas Anichini, GuidedChoice

When retirement advisors display the range of your possible retirement wealth or income, often they show the 95th percentile, the median (or 50th percentile), and the 5th percentile. GuidedChoice thinks this practice can lead to overoptimism in the minds of clients and cautions against basing your expected retirement outcome on rosy scenarios. 

This is an excerpt from NCPERS Winter 2024 issue of PERSist, originally published January 16, 2024.

Have you ever planned a road trip, only to encounter unexpected obstacles, prolonging the trip? You might encounter accidents, roadblocks, and traffic jams. Experience teaches you things can go wrong, so you might have to refresh navigation apps periodically.

 
The unexpected can also occur with your retirement savings. When saving for retirement, a lot of unplanned events might occur:
  • Market conditions might be worse than anticipated
  • Your portfolio might be different from the one assumed
  • Your earnings path might be interrupted
Their optimism misleads people into thinking the best-case is most likely
A recently published study, The Best-Case Heuristic: Relative Optimism in Relationships, Politics, and a Global Health Pandemic, found that when subjects predicted optimistic best-case, pessimistic worst-case, and most realistic scenarios, their most realistic scenarios tended to be closer to their best-case scenario prediction than to their worst-case scenario. To a retirement advisor, this finding is troubling. If people mistake the best-case scenario for the expected, the advisor needs to help clients plan without misleading them with undue optimism.
 
How should you treat optimistic projections? Ignore them 
When retirement advisors display the range of your possible retirement wealth or income, often they show the 95th percentile, the median (or 50th percentile), and the 5th percentile. We think this practice can lead to overoptimism in the minds of clients.

Simulations of growth of wealth can be heavily skewed, especially over long time periods. To illustrate this skewness, we invite you to compare the 95th and 50th percentiles of simulated wealth growth in Figure 1. This chart depicts hypothetical growth over 30 years of an account with ongoing contributions. 

Figure 1. Growth of $100,000 with ongoing contributions, current dollars, 5th through 95%iles


Source: GuidedChoice. Log return assumptions: 7% expected return, 12.5% standard deviation. Contributions in years 1 to 30 equivalent to $20,000 in current dollars. Assumed inflation rate 2.5% annually. This figure represents a hypothetical situation and is not intended as a forecast or as retirement or investment advice.

Notice after 30 years the 95th percentile projection is over twice that of the median. This is what positive skewness looks like.

Reflecting on all that could go wrong in your savings journey, we recommend you focus your attention on the bottom half of the distribution. Figure 2 displays how the bottom half of simulation results appear without the 95th percentile distracting you.

Figure 2. Growth of $100,000 with ongoing contributions, current dollars, 5th through 50%iles



Source: GuidedChoice. Log return assumptions: 7% expected return, 12.5% standard deviation. Contributions in years 1 to 30 equivalent to $20,000 in current dollars. Assumed inflation rate 2.5% annually. This figure represents a hypothetical situation and is not intended as a forecast or as retirement or investment advice. 

Takeaways
Try not to base your expected retirement outcome on rosy scenarios. If your retirement advisor shows you projections that include 95th percentile results, focus on the outcomes that are median and below.

Lots of events during your life can slow your progress to retirement security. Since you might experience some years when you cannot contribute as much as you would like, make sure you contribute as much as you can during the years when you can. 

About the author: Thomas M. Anichini, CFA, CFP, Chief Investment Strategist, joined GuidedChoice in 2011 and is currently the chief investment strategist. He is responsible for articulating our investment philosophy and methodology. Additionally, he serves on our Investment Committee and is involved in research, investment processes, and operational risk management. Prior to joining GuidedChoice, Tom held a variety of investment positions, including leading the U.S. manager research team at Mercer, managing portfolios at Westpeak Global Advisors, and as partner, director of portfolio management at Freeman Investment Management. In addition, from 2011 to 2014 he served on the Society of Actuaries Investment Section Council, including one year as chair. Thomas holds a B.S. in Actuarial Science from the University of Illinois and an M.B.A. in Finance from the University of Chicago.

Endnotes: 
  Sjåstad, H., & Van Bavel, J. (2023). The Best-Case Heuristic: Relative Optimism in Relationships, Politics, and a Global Health Pandemic. Personality and Social Psychology Bulletin, 0(0).

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