Using Your Critical Path in Retirement

Stay on Track

Man with a bike in front of a mountain.
A critical path can help you spot danger in your retirement plan. Poncho/Getty Images

A “critical path” is a term that comes from the world of project management. It is a model that looks at all the activities needed to complete a project, and then creates a timeline as to when each activity must be done so that the entire project is completed on time.

The process of creating the critical path helps determine which activities are critical to the outcome, and what happens if some activities get delayed.

By using a critical path, a project manager can determine the longest possible time a project may take (assuming lots of delays), the average time, and the shortest time (assuming everything happens on time).

Many of the features of a critical path apply to your retirement planning.

The Critical Path Applied to Retirement

One investment management firm, Asset Dedication, has trademarked the term Critical Path® as it applies to your retirement money and how long it will last. They have a proprietary process that starts by looking at all the cash inflows (savings you have while working) and cash outflows (withdrawals you will have once retired). They use that data to create a projection of the minimum amount of financial assets you would need to have left each year for your plan to work.

The Critical Path® plots the portfolio values that you would have if your portfolio stayed perfectly on track on a path that would have your assets last for exactly the length of time designated in the financial plan, generally your life expectancy plus a few years.

For example, you might run the projection out to your age 90 or 95. You would then see a graph that shows you the dollar amount of financial assets you would need to have left each year for your plan to work.

Once this path is established you can then calculate the minimum return you would need your investments to earn for the portfolio value to stay on path.

If your required minimum return is higher than 6%, you may want to reevaluate. Past data shows that about one-third of the time, retirees would have earned returns less than an average of 6%. These times of lower returns often materialize due to something called sequence of returns risk – for example, a period early on in retirement where you get below-average returns. You don’t want a plan that is likely to fail one-third of the time.

Measuring Against Your Critical Path

The Critical Path provides something you can measure against to see if you are on target. If your current financial assets are worth more than what you had originally projected in your Critical Path then you are ahead of plan. If financial assets are worth less than what you had projected, you are behind plan.

If you are ahead of plan, you have several options, such as take less investment risk, retire earlier, or spend a little more.

If you are behind plan, you also have options. You could work longer, spend a little less now so that you can save more, or plan on withdrawing less than you had planned once you are retired.

Making Your Own Critical Path

If you build and manage your own investments and financial plans, you can project what your account values are likely to be at the end of each year from now through life expectancy.

This projection, or retirement income plan, would include items such as expected deposits, withdrawals, inflation, taxes, and an assumed rate of return. Once you have a projection, each year you add up your total financial account values as shown on your December 31 statements. You compare that to where you expected to be. This do-it-yourself approach is not the same as the math required to calculate the minimum value you would need to have remaining, but it can be a good way see if you are ahead or behind your original plan.

Using a Critical Path to Make Investment Decisions

With Asset Dedication’s version of the Critical Path, it is used to make investment decisions. If you are ahead of path, you sell stocks and buy bonds. If you are behind path, you do not sell stocks; perhaps you do not rebalance at all and reinvest any excess cash or new deposits into stocks.

This process is quite different than rebalancing to a model allocation each year. Instead, you are rebalancing based on how well you are doing relative to your goals.

If you end up behind path for many years, you need to delve into why. Have you spent more than you projected? Did you save less than you projected? Have market returns been poor? Once you know why you are behind path you can make proactive changes that can help move you back onto path.

For example, in 2008/2009 my clients who were retired were behind path due to poor market returns. I recommended retirees forego any increases in withdrawals. Normally if they had withdrawn $10,000 the previous year, they would increase it to $10,300 the following year to account for a 3% inflation rate. Instead, withdrawals remained flat for several years until their portfolio was back on path.

In a few cases, I’ve had clients who are consistently behind path due to spending far more than projected. In this situation, if someone is unwilling to change their behavior, they are quite likely to run out of money too early. With the Critical Path® you can see this adverse possibility many years in advance, giving you plenty of time to make changes so that you don’t run out of money.

What I Like About This Measuring Process

Many people measure their success by comparing their rate of return to a benchmark, such as the S&P 500 Index. If your goal is to have investment returns that beat or track a benchmark, this is an appropriate measure to use. However, most people have life goals such as a desired retirement date, or retirement income that they want to achieve. The critical path concept allows you to measure against your specific goals. That is what I like about it.

Author disclosure: My firm is a client of Asset Dedication. We pay them for their services and use of their Critical Path® process.