5 Factors More Important Than Rate of Return

Key Points – 5 Factors More Important Than Rate of Return

The Rules About Sequence of Returns Risk Change the Closer You Get to Retirement
Two Big Wealth Eroding Factors in Retirement: Taxes and Health Care
Inflation, Interest Rates, and Economic Health Are Out of Your Control, But You Can Plan for Them
11 Minutes to Read | 24 Minutes to Watch

What Is More Important Than Your Rate of Return?

When it comes to building your retirement plan, a lot of people think your rate of return is the No. 1 thing to keep in mind. While it is important, your investments aren’t the main factor when it comes to your plan. Dean Barber and Bud Kasper CFP®, AIF® review five factors that are more important than your rate of return on America’s Wealth Management Show.

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5 Factors More Important Than Rate of Return

Many people think that the rate of return on your investments is the most important thing when planning for retirement. We’re going to throw a little bit of cold water on that. It’s not that the rate of return isn’t important because it obviously is. But there are other things when you are thinking about putting your retirement plan together that are more important.

In no particular order, here are the five factors that we’re going to talk about that should be considered prior to thinking about the rate of return.

Risk
Taxes
Inflation, Interest Rates, and Economic Health
Time
A Life Plan with Goals for Retirement

“If you don’t have these things, you’re really trying to fly blind with just focusing on rate of return. When you just focus on rate of return, you tend to make emotional decisions. And those emotional decisions can drastically impair your rate of return over time.” – Dean Barber

We’re going discuss each one of those things in detail. Hopefully, people can get a sense of why these things should come before you start considering rate of return. If you think about it, you could have a very bumpy ride to retirement if your only objective on investing is rate of return.

Now, if you have 15, 20, 25 years of a time horizon before retirement, we can reorder some of these things and put investing near the top of the list. But as you get close to retirement and into retirement, the rate of return becomes a less critical factor. So, let’s start with risk as our first factor that is more important than rate of return.

1. Risk

As you approach retirement, you need to pay much closer attention to the amount of risk that is in your portfolio. We can prove that by showing someone that if they have a 100% of their money in stocks that it reduces their probability of success to do the things that they want to do in retirement. That’s because there’s more risk, more drawdown.

However, if you’re working with is not held to a fiduciary standard rather than a CFP® professional, you may not have that pointed out to you. When the market is down, in our experience, non-fiduciaries stress how important it is to have a guaranteed rate of return that gives you a lifetime of income.

And it is important to have a safe withdrawal rate, but someone not held to a fiduciary standard may not mention much about investment risk or inflation, which we’ll talk about more later. We’ve talked a lot about the 4% rule lately after reviewing Morningstar’s 2023 study on safe withdrawal rates. The 4% rule states that retirees can safely withdraw 4% as an initial spending rate and still have a 90% probability of success over the course of a 30-year retirement.

The key word there, though, is initial. The 4% rule can potentially be feasible as a starting point, but it depends on your risk tolerance and these other factors more important than rate of return that we’re reviewing.

Controlling Risk in Your Portfolio

Let’s talk about how people can control risk in their portfolio. To construct the plan properly, you need to know the rate of return that your money needs to achieve on average over time to accomplish your objectives. We need to identify what that is. We call it your PRI, your Personal Return Index.

Then, we can determine how to achieve that return with the highest probability and with the least amount of risk. As you enter retirement, you want to make sure that you’re reducing that risk. You want to avoid the big drawdowns in your portfolio because a big drawdown in your portfolio can lead to you running out of money.

Nothing in your financial plan is static. Investments are no exception. If you need to make adjustments for risk, do it. Understand what you’re trying to accomplish for yourself and where your comfort level is.

Here’s a quick example about risk using the S&P 500. People will ask what the S&P 500 did and why they shouldn’t just own it. A lot of people do that because it’s what the industry teaches them to do. Only owning the S&P 500 can be very problematic if you don’t understand sequence of returns risk.

Let’s say that you’re taking a distribution every year of 5% or 6% out of your portfolio and you run into a year like 2022 where the S&P 500 was down 20%. That 5% or 6% that you’re taking out suddenly isn’t 5% or 6% anymore. It’s more than that.

Looking Back at the Dot-Com Bubble and Great Recession

Let’s run through a few more examples of market downturns. Think back to the Dot-Com Bubble and the Great Recession. If you were taking out 6% a year going into the Great Recession, that likely increased significantly to the point where the withdrawals became too steep.

“Your portfolio will tell you when it’s coming along. There’ll be an alert that’ll come out with that. It connotes that the set-it-and-forget-it approach won’t work.” – Bud Kasper, CFP®, AIF®

When you get too much equity exposure and you’re focused strictly on matching that return, you can destroy what you think is something that’s going to get you what you need for retirement.

In those scenarios, it’s important to understand what the forces are behind the scenes that are going to alter that in the future. That includes what the Federal Reserve is going to do, how the market will react to it, unemployment, and inflation is obviously a huge one with that. Again, we’ll be talking about inflation more later with it also being one of the five factors that’s more important than rate of return.

2. Taxes

The next factor that we want to discuss that’s more important than rate of return is taxes. Like Dean always says, if you live in the United States and either have money or make money, taxes are going to be a fact of your life.

What people don’t understand, though, is that you can reduce the amount of taxes that you pay over your lifetime with a forward-looking tax plan. Notice that we didn’t say in a given year. Tax planning focuses on reducing taxes over your lifetime.

“The truth is that in retirement, you have a unique ability to control your taxes unlike any other time in your life because you have different sources of income and get to control where that income is going to come from.” – Dean Barber

That’s why we have CPAs in-house that sit alongside our CFP® professionals and clients to create the financial plan. Then, the CPA focuses on creating the tax plan to see how much they can reduce their tax burden over time. We mentioned several examples of tax planning opportunities that our CPAs look for when reviewing financial plans within our Tax Reduction Strategies guide. Download your copy below and examine if those strategies could benefit you.

Tax Reduction Strategies

This is a very dynamic planning scenario. It’s not one-and-done type of deal. It’s something that changes and evolves as time goes on and as the government changes the rules on taxes. But it is something that people can control. You need to start thinking about tax planning at least 10 years before retirement because tax allocation is just as critical, if not more critical than asset allocation.

When we meet with a client or prospective client, it usually doesn’t take long for taxes to be a part of the discussion. Still, it happens all too often that people want to talk about rate of return first. Eventually, we circle back to talking about taxes and the other factors that are more important than rate of return.

Controlling Your Taxes

For people heading into retirement, taxes and health care are usually your two biggest expenses. How can you control your health care expenses? A big part of it involves preventative care by eating healthy, exercising, etc.

You can also control your taxes through the decisions you make. Almost any decision that you make from a financial perspective will show up at some point on your tax return. Working alongside a CFP® professional and a CPA to create your retirement plan and then distribution plan is where the tax savings really comes in.

It’s the mixing and matching of income from Social Security, taxable accounts, tax-deferred accounts like IRAs and 401(k)s, and then tax-free accounts like Roth IRAs and Roth 401(k)s. It’s the combination of how and when you take the distributions from those different buckets that will impact your ability to pay less taxes with the same amount of income.

Don’t Let Additional Taxes Sneak Up on You

A lot of people don’t realize that Social Security can become taxable and don’t know the formula or how to plan around it to reduce taxes.

“Yes, you can take it at 62, but you can postpone that to maximize the results of the plan.” – Bud Kasper, CFP®, AIF®

Many people also don’t understand that Medicare is impacted by the amount of income that you have. There is planning that can keep you in the lowest part of Medicare taxation. But that can oftentimes be overlooked, as people are more focused on things like their rate of return or paying as little tax as possible in one year.

3. Inflation, Interest Rates, and Economic Health

As we continue to talk about five factors more important than rate of return, let’s discuss inflation, interest rates, and economic health. This is kind of three points in one, but they’re all crucial factors in your overall plan. Let’s tackle inflation first because we call it the silent killer.

Inflation never causes a person to go broke, but it will cause people to live like they’re broke. If you haven’t properly planned for inflation in your retirement plan, you could be in for a very rude awakening. Over the past several years, we’ve had several people come to us thinking that they already have a solid financial plan. One of the biggest flaws we’ve seen with most of those plans, though, is that they haven’t properly planned for inflation.

Factoring Inflation into Your Financial Plan

For example, let’s say that someone wants to spend $60,000 a year and inflate that by 2% a year. That won’t work because they’re not just spending $60,000 a year. Some of that will likely be used for health care. Some of that will go toward meals, entertainment, and travel. And some of it might go toward a mortgage. They’ll spend money on all those things, and they all inflate at different rates.

It’s critical that you apply different inflation rates to each one of those pieces when you build your plan. And that needs to be updated at least once a year. Let’s say that you spent $X-amount on health care in 2023. What is your budget for health care in 2024? Have you received increases in your health care premiums? Have your Medicare premiums gone up or did your Medicare supplement premium go up?

We put in a 6.5% inflation rate for health care expenses compared to a 4% inflation rate for goods and other basic needs. Your mortgage wouldn’t be included in those basic needs, though, if you have one in retirement. Why? Because your mortgage rate won’t inflate. It’s at a fixed rate. All those things need to be taken into consideration to have an accurate plan. We mentioned each of those things in our Retirement Plan Checklist, which is a resource that’s designed to assess your retirement readiness. Download your copy today!

Retirement Plan Checklist

A Couple of Retirement Risks That Are Out of Your Control … But You Can Still Plan for Them

Economic health and interest rates are also things that are out of your control, but you can plan for them. They’re two other factors that are more important than rate of return, and they both have a direct impact on the risk of your portfolio.

“Interest rates, inflation, and economic health are things that we can actually stress test through. We can take a portfolio and stress test it through all the economic conditions that we’ve had in the past.” – Dean Barber

From March 2022 to December 2023, the Fed funds rate has risen from a 0%-0.25% target range to 5.25%-5.5% target range. Those rate hikes put traditional bonds at risk. So, while bonds typically provide stabilization within your portfolio, that hasn’t been the case over the past couple of years.

4. Time

That brings us to our fourth factor that is more important than rate of return, and that’s time. You can look at time in two ways. One mindset is “How much time do I have until I retire?” or “How much time do I have to let my wealth accumulate?” The other way to look at time is, “How much time do I have after I stop working until I pass on?”

Just because your parents lived to a certain age doesn’t mean that will be the same case for you. There’s no way to know the answer to that. Dean has mentioned it a number of times recently on America’s Wealth Management Show, but he witnessed his grandfather fall victim to that thinking. He thought he’d live until 76 since that’s how long his dad lived, but ended up living until 87. Dean’s grandfather had to move in with Dean’s mom for the last decade of his life because he didn’t have enough money to support himself.

Planning for a Longer Life Expectancy

So, when we build someone’s financial plan, we plan for a longer life expectancy. More time puts more stress on the plan itself. If you can live to 95 or 100 and your plan says you can have enough money to do that, that’s great. But if you do live a shorter time despite having that longer life expectancy factored into your plan, you’re just going to leave more money to your beneficiaries or to your surviving spouse. That obviously helps them after you’re gone.

“The most precious commodity that we all have is time.” – Dean Barber

5. A Life Plan with Goals for Retirement

Even more critical than time is our fifth factor that’s more important than rate of return. That’s having a life plan with goals for retirement. Don’t just think about your retirement in numbers. It’s about what you’re going to do with the rest of your life.

What’s Important to You?

Early on in the financial planning process, we go through a meeting with people called a prioritization exercise. During that prioritization exercise, we coach couples and individuals to try to discover what the most important things are in their lives and what they want life to be like over the next 10, 15, 20, 25, 30 years. What’s most important to you?

“You need to stop thinking about the past and step into the future. You need to spend time speaking with the person that you’re going to spend the most time with in retirement about what you want those years to look like. What are the things that you want to do?” – Dean Barber

A lot of times, one spouse will learn something new about their partner. It’s prioritizing the things in your life that you want to accomplish. Those are your reasons to get up in the morning. You’re doing the things that you want to do for the reasons that are important to you. It’s not because you need a paycheck. That’s what we call financial independence.

Once you have that prioritization exercise—that life plan—put together, then you can come back and start putting numbers to that. Then, measure the resources that you have. That’s when the financial plan really begins to come together.

There’s an Art and Science to Financial Planning

If you just want to retire and want $X-amount a month to spend, put some more thought into it. That’s just back of the envelope math. That’s where the art of financial planning comes in. There’s an art part of it, and there’s a science part of it.

The art of it is connecting with your CFP® professional so that they understand what’s important to you. That way when they’re looking at your financial plan, underlying investments, your tax planning, and other factors, they’re thinking about you and what’s important in your life. You don’t become a number that way.

Needs, Wants, and Wishes

When we start the financial planning process, we divide it up into three factors: needs, wants, and wishes. The needs are the things that are essential to everyday life. That’s the way you live. It’s your existence.

Then the wants are things like annual vacations. For the wishes, if things really work out and you can accumulate more wealth than what you started with, now you might change that vacation to a European vacation. You might stay for two weeks instead of one.

It’s your CFP® professional’s job to help identify these things for you and recharacterize them in terms of priorities. It’s making sure the needs are met first, then the wants, and the wishes hopefully will come true as well. That’s planning. That’s the heart of the prioritization exercise.

When people are working, most will identify themselves with their profession. They lose sight of who they are and the things that are most important in their life. There’s a real paradigm shift that takes place when you go from work to retirement or from work to not working, however you want to consider it.

There’s a lot of self-discovery that needs to happen to make that transition smoothly. For a lot of people, it becomes a very uneasy time because it’s uncertain. They don’t know what to expect in that retirement timeframe.

Leaving a Living Legacy

And if you’re passionate about leaving a legacy, retirement isn’t just about you and your spouse. A lot of people will just leave an inheritance for their beneficiaries for after they pass away. That’s perfectly fine, but think about this. Are there things that you would do for your kids now that you could watch them enjoy? At the same time, you could experience the sacrifice that you’ve made over your lifetime and see how it impacts their lives.

If you want to gift money to your kids and or grandkids while you’re still living and it won’t impact your ability to live the way that you want to live, let’s look into it and build it into your plan. It creates much more of a living legacy.

Getting Clarity from Your Financial Plan

A lot of times, families won’t even have these discussions. It’s like the discussion about their parents’ wealth is taboo and you can’t talk about it. We’ve seen instances where the parents will pass away and the kids suddenly find out that they could’ve have spent much more but didn’t. That can happen without the clarity of a financial plan.

There Are Several Factors More Important Than Rate of Return

It all starts with having a financial plan that considers all these things that are more important than rate of return. If you don’t have a financial plan, let’s change that. To start building your plan, start a conversation with our team here.

Schedule a Meeting

The clarity and confidence that you can receive from a financial plan can make a profound impact as you’re navigating your way to and through retirement. We just skimmed the surface in terms of what needs to be considered during the financial planning process. Start planning today with our team of professionals who are obligated to put your needs, wants, and wishes ahead of their own.

5 Factors More Important Than Rate of Return | Watch Guide

00:00 – Introduction
01:56 – #1: Risk
06:48 – #2: Taxes
10:15 – #3: Inflation, Interest Rates, and Economic Health
13:39 – #4: Time
15:56 – #5: A Life Plan with Goals for Retirement
19:35 – What We Learned Today

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The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Adviser. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.