Stress Testing Your Plan: Where Art Meets Science
In the ever-changing landscape of personal finance and markets, creating a robust financial plan is both an art and a science. At Mirus Planning, we understand that the world has already shifted once we print our financial projections. However, these plans serve as a crucial framework, allowing us to navigate the complexities of your financial future thoughtfully.
In this blog post, we'll reveal our “evidence-based” approach to financial planning and discuss the key assumptions forming the foundation of our planning projections, from inflation rates to spending patterns and long-term care considerations. By sharing our methodology and the data behind our reporting, we aim to give you a deeper understanding of how we craft financial plans tailored to your circumstances.
We balance historical trends, current market indicators, and forward-looking projections to create a comprehensive roadmap for your financial journey. Whether you're curious about how we account for market volatility or wondering about our approach to retirement spending, this post will offer valuable insights into the thoughtful process behind your Mirus financial plans.
Inflation: Current Update & Forecasted Future
In what was a relative afterthought for the previous decade, inflation became a primary focus for all consumers after several COVID-19 crisis-related factors caused the prices of many goods and services to rise rapidly. For years, 3% annual inflation has been the Mirus Planning baseline assumption in our financial plans. As you can see from the chart below, we spent the entire past decade at or below this 3% lineup until 2021:
Consumer Price Index (CPI) excluding shelter costs (rent, “Owners equivalent rent”). This is an interesting data point as many of our clients are homeowners not impacted by rising rents.
However, since this period of high inflation, our baseline expectations are unchanged at 3% annually. As the graph above shows, inflation excluding shelter costs (rents) is well below 3% over the past year in U.S cities. We believe this recent period of abnormally high inflation is ending, and we are not unique in that assessment, as we will review below. We increased our financial planning clients' annual spending assumptions by 10-15% as a one-time adjustment to their financial plans and then used 3% yearly inflation from this higher spending number.
One key metric we use to help determine if our inflation projections are appropriate is monitoring the 5-year & 10-year “breakeven inflation rate.” This financial market-based metric shows where bond market investors believe the inflation rate will be over the following 5- & 10-year periods. How is this rate determined? The short answer is that bonds called TIPS (Treasury Inflation-Protected Securities) are indexed to inflation. These U.S. government bonds pay a far lower interest rate than regular Treasury bonds that aren’t indexed to inflation. With the same maturity date, this interest rate spread between these two bond types determines where bond market investors think inflation will be. The Treasury Bond market is a highly liquid, multi-trillion-dollar market, making it a key information source for investor expectations toward inflation.
Market expectations for annualized inflation over the next 5 & 10 year time periods, as determined by the market spread between Treasury Bonds and Inflation-Protected Treasury Bonds.
The graph shows that the market doesn’t expect inflation to be much higher than 2% annually over the next 5 and 10 years. However, we will still maintain our 3% inflation assumption in our planning, as we’d prefer the margin of error to benefit our clients. It is worth noting that these are just our baseline assumptions as well. We frequently run “high inflation” scenarios for our clients to ensure their plans are successful in such a scenario.
Spending: Patterns and Discretionary Spending Variance
Our annual inflation assumptions are directly indexed off our household spending assumptions. It can take several months, if not years, to fully understand household spending levels for a typical year. Still, it is fundamental to understand these spending levels for accurate financial planning. In our financial planning assumptions, we assume spending is maintained annually while also compounding at the 3% annual inflation level. One way to “stress test” the financial plan. However, economic data suggests that many clients are in a downward spending phase. Internal data for JPM Chase Bank clients with $1-3 million in portfolio assets experience a peak in spending near the ages of 50-55. This age group, often considered the “sandwich generation, " potentially supports both children and parents at this time. From there, spending slowly tappers until individuals reach their 90s and healthcare costs increase more rapidly than other expenses decline. This is another reason we like to break spending down into different categories: basic living expenses, housing expenses, travel expenses, healthcare expenses, etc.
Travel and vacation home-related expenses represent the most significant discretionary spending category, with the broadest dispersion among our retired clients' financial plans. This variability is well seen by recent S&P Global Market Intelligence research, which reveals broad travel preferences among retirees. While the “average” retiree takes roughly three trips annually, the study found that 20% of retirees didn't travel in the past year, and another 20% embarked on more than five trips during the same period. This wide variation underscores the importance of personalized planning conversations with our clients to refine our projections accordingly. Like the spending trends noted above, this expense declines as clients age.
Long-Term Care Planning: Difficult to Predict
Long-term care planning is essential for all retirees to consider ahead of such a need. A 2022 report from the U.S. Department of Health and Human Services' Office suggests that more than 56% of 65-year-olds today will experience a disability severe enough to require long-term care service needs. This is one aspect of financial planning. However, that is challenging to project due to the extreme differences in potential long-term care needs, as the graph below shows. Approximately 26% of retirees 65+ today will have lifetime long-term care needs of less than $25k, while 30% will have more than $250k. You will also note that women have, on average, higher long-term care expenses than men, primarily due to their increased longevity requiring more extended care. According to the U.S. HHS report, these include expenses covered by private and public insurance programs; families pay around 40% out of pocket. Source
Source: JPMorgan Asset Management, Guide to The Markets Q3 2024
It is important to note that most of the time, care is progressive, typically starting with unpaid care from family and friends before transitioning to paid care on a progressive scale as severity increases. Medicare does not cover long-term care expenses. Medicaid does cover these expenses but requires strict asset and income limits to receive these benefits, a route many don’t opt into if it can be avoided. At Mirus Planning, we often “stress test” financial plans by projecting extensive long-term care needs to see the viability of such potential expenses. Some clients have long-term care insurance, while others will “self-insure” such an expense.
Investment Returns
Another essential ingredient of our financial planning process is projecting investment returns for client portfolios. At Mirus Planning, we understand that future market performance is inherently uncertain. Our approach to estimating investment returns is based on carefully analyzing historical data, current market conditions, and forward-looking economic indicators. We adjust these projections to each client's unique investment allocation, recognizing that different asset mixes will yield varying return profiles over time. While we don't rely on overly optimistic assumptions, we also aim to avoid being overly conservative, as this could lead to unnecessary restrictions on your lifestyle or missed opportunities. It's important to note that these projections are not guarantees but educated estimates that help guide our planning process. We regularly review and adjust these assumptions to remain relevant in changing market environments. By incorporating these thoughtful return projections into your financial plan, we can better assess the likelihood of achieving your long-term financial goals and make informed decisions about savings, spending, and investment strategies.
As many clients know, we advocate a balanced investing approach for most retired clients. A 60/40 portfolio (60% stock, 40% bonds) is a standard benchmark for such a balanced portfolio. JPMorgan's research shows that a U.S. 60/40 portfolio has returned, on average, over 8% since 1950.
Our financial planning projections use a more conservative 5-6% forward return assumption for such a portfolio today. We prefer our error to benefit client portfolios rather than paint a potentially unstainable picture with high return assumptions. This is another area where we frequently run unique stress tests for clients depending on their concerns about reliance on portfolio returns. We also re-run plans yearly for clients to see how current market returns have affected their financial plans.
This is an essential reminder that the stock market declines, on average, around 15% each year. Portfolio volatility is typical, and a key to successful financial planning is sticking with the strategy in all market environments.
We focus on strategic adjustments that change with market cycles to effectively manage cash and bonds in client portfolios as interest rates change. The chart below from PIMCO illustrates how bond returns typically respond during rate hikes and cutting cycles. Historically, cash tends to outperform when the Federal Reserve raises rates, but as rates begin to decline, bonds often experience a reversal in performance, offering more attractive returns. We spent much of 2022 and 2023 advocating for clients to take advantage of abnormally high rates on cash without having to experience interest rate volatility. Now that the Fed is beginning to cut rates, we are advocating for clients to go the other direction and lock in higher yields in traditional bond investments. Cash yields typically decline dramatically compared to the overall fixed-income market during Fed rate-cut cycles. This is an area of the market where we use historical data and forward-looking forecasts to determine appropriate investment decisions for our clients.
In the months after the Federal Reserve cuts rates, core fixed-income instruments typically outperform cash-like instruments by a wide margin.
Closing Words: “Plann-ing” Matters, Not Just Creating a Plan
As we've explored throughout this post, financial planning is a complex process that involves several variables and assumptions. At Mirus Planning, we recognize that creating a static financial plan is insufficient in today's rapidly changing world. Instead, we advocate for an ongoing, adaptive approach to financial planning. This strategy allows us to:
Regularly reassess and update our assumptions
Incorporate new life events and changing priorities in our clients’ lives
Adjust strategies in response to shifting market conditions
Ensure your plan remains aligned with your evolving goals
Our job as financial planners goes beyond crafting a single, idealized plan. We strive to prepare our clients for various potential personal and financial outcomes. Not all our planning discussions will be easy or fun, as it is our job to have difficult conversations when and if needed. We aim to build resilience in your financial strategy by stress-testing plans and running various scenarios. Your financial plan is a living document that should grow and change with you. Regular check-ins and open communication with your financial team are crucial to maintaining a robust and relevant financial strategy. By working together consistently, we can navigate life's uncertainties and help ensure your financial success across many potential scenarios. In the end, while we can't predict the future with certainty, we can certainly plan for it.
At Mirus Planning, we're committed to guiding you through life's financial journey, adapting our guidance as needed, and helping you achieve success no matter what challenges or opportunities may arise. We hope you enjoyed learning more about how we think about crafting our long-term financial planning projections. And we just scratched the surface on several essential planning topics. Stay tuned for more “Money Conversations” from me in the future! And please feel free to pass this post to friends and family who you think would benefit from exploring such topics!
Best regards,
Kyle Temple
CFP®, CPWA®
