As mentioned in Financial Planning Assumptions - Part 1, in-order to create a financial plan you will need to rely on a variety of assumptions. These assumptions will be required to forecast and estimate your future financial situation. In addition to estimating investment rates of return and inflation, you will also need to estimate the following assumptions for inclusion in your comprehensive financial plan.
Assuming Life Expectancy
A financial plan should include a lifelong cash flow forecast. This will ensure that you understand about how much money you will need though all phases of your life. The best case scenario is that you will have enough money to live comfortably in your golden years. To ensure that you do not run out of money during retirement, you will have to use an estimate of your life expectancy in your cash flow analysis.
Two of the most common methods of estimating life expectancy includes using an actuarial life table and planning to 100 years old. Using an actuarial table provides an estimated life span based on year of birth. The U.S. Social Security Administration provides actuarial tables on their website.
Despite the mathematical savvy of the actuarial table, I prefer to estimate all life spans to 100 years of age. This method reduces the risk of running out of money in retirement.
Retirement Planning Assumptions
Looking into the future, it is difficult to determine what your life and career will look like at certain date or age. Due to this difficulty, you will need to make a few assumptions concerning your eventual retirement.
The assumptions that you will need to place in your retirement plan include: date of retirement, income needs during retirement, amount of monthly Social Security benefit and the value of your investment accounts upon retirement.
Your anticipated date of retirement is highly contingent on your cash flow needs and preferred lifestyle. In the absence of any additional data, estimating a retirement age of 62 - 67 is appropriate. Your income needs during retirement can be estimated by creating a budget or using a few common rules of thumb.
Many of us will rely on Social Security benefits for a portion of our retirement income. This amount will have to be assumed due to the probability that Congress will lower these benefits in the future. To estimate these benefits at retirement I like to use the models on the Social Security Administration's website. Finally, you should take a look at your investment plan and forecast the value of your portfolio at your retirement age.
Guessing Future Tax Rates
The last major assumption you will have to incorporate into your financial plan concerns tax rates. Tax rates are as difficult to estimate as Social Security benefits due to the politics that influence them. This is why I rather refer to tax rate forecasting as "guessing".
There are three main tax rates that influences the outcome of your financial plan. These rates includes taxes on income (salary), capital gains (investments) and estates (property transfers).
Due to the uncertainty of these rates, many financial analysts keep them constant (place current rates into the financial plan) when estimating future cash flow. However for a robust comprehensive financial plan, I recommend performing a "what-if" analysis to see how a change in rates effects your long-term financial success.
When developing a financial plan you will be required to include a few assumptions into your analysis. These assumptions can have a significant impact the outcome of your plan, thus your best effort should go into their accuracy.