The Unrealistic Optimism That Threatens Retirement Security

Abstract

The US is facing a retirement crisis. Almost half of all American families have no retirement savings. A disturbingly large number of investors think they are on a path toward a comfortable retirement, but they are unlikely to reach their destination due to their unrealistically optimistic growth forecasts for their retirement savings. This article examines the sources of this unwarranted optimism. First, some investors forecast savings growth rates that assume they will reinvest dividends, but they do not. Second, investors earn lower rates of returns than the mutual funds they invest in. Third, they fail to properly account for the costs associated with investing—inflation, expense ratios, and taxes. Investment professionals are very familiar with how these factors work against accumulating savings. Much less attention, however, has been directed at how overly optimistic forecasts of these factors threaten retirement security. This article examines these issues. In addition, the article shows how properly incorporating the factors into retirement plans enables retirement savers and financial advisors to make the timely changes needed to prevent a retirement nightmare.

TOPICS: Wealth management, retirement, pension funds, portfolio theory

Key Findings

• • A majority of polled workers express optimism about their ability to finance a comfortable retirement, but those who forecast an overly optimistic savings growth rates are unlikely to reach their retirement goal.

• • The principal sources of overly optimistic savings growth rate forecasts include bullish market return forecasts, failure to reinvest dividends, underperforming the equity funds that the investors invest in, and a failure to properly account for inflation, expense ratios, and taxes.

• • Prospects for achieving retirement savings targets improve with a combination of better forecasts of the factors affecting the savings growth rate, avoiding poor market timing, and lowering expense ratios with low-cost index funds.