By Steve Tepper, CFP®, MBA

At its most basic, retirement planning is a mathematical exercise. Inputs include annual savings during your working years, expected return on investments, expected retirement date, expected household expenses during retirement, and life expectancy.

Did ya notice that one word popped up an awful lot there? A fairly large amount of the financial planning process is based on expectations. The good news is we have a lot of control over several of those expectations, like how much we contribute to our savings while we are working or the date we plan to retire.

But other assumptions can end up straying from our expectations, with little we can do to control them. Perhaps the best example is expected return. In modeling, we look at past returns for similar investments or portfolios to estimate what the return will be going forward.

According to Dimensional Fund Advisors, the historical annual return on the S&P 500 index going all the way back to 1926 is 6.9%. Of course, the return is not fixed at 6.9% each year. In fact, I couldn’t find a single year in which the return was 6.9%. Most years, it is significantly higher or lower than that. In 1931, the index fell 37.5%, and in 1954, it rose 53.8%. In fact, in 31 of the 93 years, exactly one-third of the time, the index either rose or fell more than 20%. But all the ups and downs averaged out to 6.9%.

Why is this important in financial planning? Because if the strategy includes investing in large U.S. companies (and it probably should), then we are going to make an assumption about the return we expect to get for that investment, and that 6.9% historical return is as good a starting point as any.

Other investments might be assigned similar assumptions about expected return; then math does its job to compute how your money will grow during your earnings years, whether it will continue to grow in retirement, and if or when you will run out of money. We can even chart out how much we expect the portfolio to be worth year by year.

So that expected return is pretty darned important.

But given our lack of control over that number, actual returns can, and often will be, very far off of what we assumed. At any given point, our portfolio value could be very different than what the year-by-year chart said it would be.

So we should entertain the questions: Do we change the financial plan as we find our actual portfolio value straying from the target we set? Or do we just let it ride and stick with the plan, knowing swings will come in the opposite direction that will eventually bring the value of our nest egg more in line with the plan?

A researcher in Spain explored that exact question, and his results were recently published in the Journal of Financial Planning. The article is pretty technical, but rather than breaking out my 25-year-old MBA textbooks to refresh myself on C1/(1+R) - C2/(1+R)2-…- C39/(1+R)39 + P40/(1+R)40, I’ll just stick with the findings that were laid out in English.

The two scenarios studied were the “stick to the plan” option (“S2P”) and a dynamic strategy to adjust the plan to manage to the target (“M2T.”) Within M2T, several options were explored, including changing asset allocation or adjusting the amount contributed each year.

Not surprisingly (but still reassuring when backed up by academia), asset allocation change did not have as positive an impact as adjusting savings. Simply put, and particularly important when markets underperform, there is no better defensive move than increasing your contributions to your account. Granted, that might not always be possible, particularly in an economic downturn, but the study reaffirms what we tell clients looking to “flee to safety” after markets have fallen: Not the best move.

As occurs sometimes in academic studies, the best plan on paper is impractical in the real world, and the researcher acknowledges that. Mathematically, the most effective method to hit your number, the amount of money you think you will need at retirement to meet all your financial wants and needs for the rest of your life, is to compare the yearly balance with the plan balance, and deposit the entire amount of the shortfall, or withdraw the entire amount of excess. That method is 100% foolproof. Each year, you will be 100% on target all the way through to retirement.

But what if the market has a particularly bad year and your shortfall is tens of thousands of dollars—or hundreds of thousands? If you actually came up with that amount to deposit into your account, as your advisor I’d have to ask you, “Why wasn’t that money invested in the first place?!”

Chances are you don’t have the money to make up for a large shortfall in any particular year, and while you could withdraw a big surplus if the markets overperform, is that really a better choice than keeping that money in the account earmarked for retirement? What if your retirement money is in an IRA account? Do you want to pay taxes, and possibly a penalty, for withdrawing that money? And if the account is an employer plan like a 401(k), you may not be able to withdraw the surplus at all.

Bottom line: A better approach is to stay aware of how your account is growing compared to plan, particularly as you get close to retirement, and contribute more any time you are able whether the account balance is above or below target. And don’t take money out just because it’s there. That’s a good strategy to end up with nothing.

Markets will rise and fall, which makes investing in them a risky undertaking. A disciplined approach remains the most effective way to get rewarded for taking the risk.