The 3 Most Important Words in Financial Planning

September 05, 2013

According to this article, the three most important words when it comes to investing are the “margin of safety.” The article discusses how inaccurate people tend to be at making predictions about things like the economy, industry trends, and business growth. Since this unpredictability can wreak havoc on investment plans, many of the top investment experts recommend investing with a margin of safety, which is “simply the distance between your predictions coming true and needing those predictions to come true. You can still try to predict the future, but a margin of safety gives you room for error to be wrong.” In other words, rather than pick the investment that needs to grow at 10% per year to payoff, pick the one that could grow at 10% but would still be a good investment if it only grew at 5% with anything else being gravy on top.

This is not only a good rule when it comes to investing but to financial planning in general. For example, a margin of safety is essentially the whole idea of having emergency savings. They provide a buffer from going into debt or not being able to make your mortgage or car payments when your spending plans don’t go exactly as planned. (The traditional recommendation is to have at least 3-6 months’ worth of necessary expense in an emergency fund but some experts have increased that to 9-12 months because of the weak economy and high unemployment rate. )

The same is true of insurance and estate planning. Make sure you’re adequately insured and have documents like a health care directive and power of attorney in place. Otherwise, you’re betting you and your family’s well-being that nothing will ever happen to you. I don’t know about you but that’s not a bet I would be willing to take.

It’s also vital to have a margin of safety in your retirement planning. Entering numbers into a retirement calculator that are overly optimistic will produce a case of the old garbage in, garbage out and by encouraging a false sense of security, can actually be worse than not running a calculation at all. Here are some inputs that you’ll want to have a margin of safety for:

Retirement Expenses: When doing retirement projections, you want to aim for a retirement income that’s a bit higher than you think you’ll need. For one thing, tax rates are likely to be higher given the rising national debt and cost of entitlement programs. At the very least, you’ll also probably need to spend more than you do now on health care. A recent Fidelity study estimated that a 65-yr old couple retiring today will need about $220k to cover health care costs throughout their lifetime. That doesn’t even factor in long term care costs or future cuts in Medicare that will likely be needed to keep the program solvent. Yet a survey showed that about half of pre-retirees expect to only need $50k to cover health care costs in retirement.

Social Security: Don’t assume you’ll get the full amount listed on your statement or on the website. Starting in about 20 years, Social Security is projected to only be able to pay 75-80% of expected benefits so assume you’ll get no more than 75% of what’s promised. If the politicians exempt current beneficiaries from cuts as expected, the reduction could be even greater for younger people. The same goes for higher income people as there has been talk of exempting lower income people from cuts as well.

Life Expectancy: You also don’t want to assume an average life expectancy. After all, there’s at least a 50% chance that you’ll live past average and that doesn’t even factor in rising life expectancies due to improving medical technologies. If you do live past your assumed life expectancy, you could run out of money in retirement. On the other hand, if you don’t live that long, it just means leaving a larger inheritance for your heirs. To be on the safe side, you might want to plan to live to 90, 95, or even 100.

Inflation: Official inflation rates are currently only about 2% but there are a couple of reasons you’ll want to assume a higher inflation rate. First, many people argue that changes to the methodology used to measure inflation are underestimating the real  increase in the cost of living. Second, inflation rates could rise if the government tries to inflate itself out of the growing national debt and entitlement obligations as governments have typically done in the past.

Investment Rates of Return: Whenever you’re saving for any goal, you want to be conservative with your assumed rates of return too. This is especially true because historical returns are largely from time periods when bonds were paying much higher interest rates and both stocks and bonds were boosted by falling interest rates. With rates expected to rise, stocks and bonds could both be facing strong headwinds. Some investment experts even talk about a “New Normal,” in which stock returns could average only 4-5% going forward as opposed to the 7% historical real returns written about in Jeremy Siegel’s famous books Stocks for the Long Run.

Putting all of this together means you’ll need to save more. If things turn out better than expected, you’ll be able to retire sooner or with a larger income. That’s why no one ever complained about saving too much. But if not, you’ll be glad you chose to be safe rather than sorry.