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Author: libc Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 75537  
Subject: Retirement Consideration Date: 2/23/2001 9:20 AM
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Frankly, the subject of constant average interest rate combined with a severe stock market decline, and the inability of having the proper software to make a realistic interest rate assumption for managing one's money during retirement...has convinced me that a "guaranteed lifetime income" through an annuity is not the worse-case scenario. Using an annuity to produce retirement income will make constant average return, compound return, etc. an unnecessary discussion.

In addition, although an annuity is not the ideal financial service vehicle to transfer wealth to your heirs, and its rate of return may be minimal when compared to the average return for common stocks, the peace of mind it provides by way of a monthly check in the mailbox or by direct deposit...may be worth the price.
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The Serious Flaw Regarding Constant Average Interest Rate!

"If we could be sure that our investments would earn the same return year after year, and that interest and inflation rates would remain stable into the future, financial planning would be easy. It would simply be a matter of accurately estimating our contributions to those investments over time, and our anticipated future cash needs to achieve our goals.

Unfortunately, for any given year in the future, we cannot accurately predict the return rate on investments, inflation rate, or interest rate. Yet, most financial plans assume a constant average rate of return, inflation rate and interest rate going forward. That's a very risky assumption, since these rates will certainly vary from year to year.

Consider the following simple example:

You have a $100 investment portfolio and your assumption is that you will earn an average of 10% per year on that portfolio. Earning 10% each year, your portfolio value would grow to $121 after two years. Given the market in recent years, a reasonable assumption, right? Not so fast! What if in Year 1 your portfolio earns -5% and in Year 2 it earns 25% (not unlikely given recent market volatility). In this case, your average return is still 10% over the two years, but your portfolio value grows to only $118.75. Given this simple yet graphic example, it's clear to see that by assuming an average rate of return on your investments over the full length of your financial plan, you could be creating unreasonably high expectations of achieving your goals."

Source: http://www.finportfolio.com
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However, in reality a value of $118.75 after two years is a 8.97 percent compound return not 10 percent compound.

P.S. The constant average interest rate methodology is most likely used on all non-term life insurance ledger statements, systematic withdrawal calculations, and mutual fund performance results. In my judgment a proper explanation of this system is essential.

LIBC
William D. Brownlie, CLU, ChFC, CIP, LIA

P.P.S. I look forward to your comments.

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