Retirement planning has quite a lot in common with military planning. There’s a famous saying: “No plan survives contact with the enemy”. In the case of retirement planning, the ‘enemy’ consists mainly of political, economic, market and life events. Both types of planning need to take uncertainty into account.
Donald Rumsfeld was a rather controversial US Secretary of Defence, serving under both Presidents Gerald Ford and George W Bush. Possibly you’ll remember him for the following statement he made in a press briefing in 2002, in which he tried to explain uncertainty in military planning:
“There are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don’t know we don’t know.”
If you find that very cryptic, you’re not alone! But you may have noticed that Rumsfeld didn’t mention unknown knowns. In 2013, an interviewer asked him how he would define unknown knowns. His answer was:
“Things that you know, that you don’t know you know.”
Rumsfeld’s language tied itself in knots, though he didn’t invent the concept. Let’s look more closely at each of the four categories, and see how they can prove useful for retirement planning.
The Need-To-Knows For Financial Planning
These are the known knowns, or the “things we know we know” according to Rumsfeld. In other words, they are facts that we know for sure, or about which we decide to make assumptions.
In a game of chess, for example, we know the position of all the pieces on the board. Even in a game of poker, which involves chance, we know the cards we hold. These are known knowns.
In retirement planning, we might know, or be reasonably sure of, a number of facts. For example:
- Date of birth
- Salary
- State pension start date
- Bank balance
- Risk tolerance
There are other things that we could also treat as known knowns, by making reasonable assumptions, such as:
- Planned retirement date from employment
- Current value of a home
- Energy costs
Plan For Uncertainty In Your Financial Plan
Rumsfeld said “we know there are some things we do not know” as his definition of known unknowns. Okay, but what does that really mean? As an example, in poker the cards held by our opponents are unknown. However, we can calculate the likelihood of our opponents holding a better or worse hand than us, so that makes them known unknowns.
In the context of retirement planning, it means that there are some things that we know about, which have some degree of uncertainty, but about which we can make educated estimates.
One thing that we know for sure is that one day we’ll die. However exactly when we’ll die is uncertain. Our date of death is a prime example of a known unknown. Using statistical analysis, we can predict the likelihood of our dying within any particular future period. That’s what insurance companies do when they offer us life insurance. They’re pretty good at it, since they make money from it. In fact, the entire insurance industry is about spreading the risks associated with known unknowns.
In retirement planning, our longevity is our unavoidable uncertainty, or known unknown. But there are others. Take investment returns, for example. Virtually all investments carry some form of risk. This means that either their income or their valuation or both can rise and fall. Normally, the better the average return, the higher the risk.
Traders and investors have carried out plenty of analysis to help quantify the risks associated with various classes of investment. So investment returns is another example of known unknowns.
A further example of a known unknown is the rate of inflation, which can reasonably be assumed to fluctuate randomly, but constrained by rules.
Things You Might Not Consider For Your Retirement Plan
Rumsfeld described unknown unknowns as things “we don’t know we don’t know”. Very mysterious! For our purposes, unknown unknowns are things that may or may not ever happen, and which are impossible or impractical to quantify.
There are some things that we may not even have thought of at all. Sorry, I’m afraid I can’t give you any examples, because I haven’t thought of them yet!
In retirement planning, there may be other things we’ve thought of, but have little or no idea of the financial impact. These could include:
- A sudden debilitating illness
- Senility requiring a care home
- One of our banks going bust
So how do we plan for unknown unknowns, which are the ultimate uncertainty? There are two ways:
- Maybe we could take out an insurance policy. For example, critical illness cover would mitigate the financial effects of a debilitating illness.
- We could earmark a sum of money to cover truly unknown contingencies.
Making Decisions When Retirement Planning
As I noted earlier, unknown knowns were only an afterthought for Rumsfeld. In response to a later interview question, he said that they were “things that you know, that you don’t know you know”. I don’t think he had any examples up his sleeve. Nonetheless, unknown knowns are a crucial category when it comes to retirement planning, or for any planning for that matter.
Unknown knowns represent planning decisions we’ve yet to make. Once we’ve made them, they’re known. Until then, they’re unknown. The key difference between unknown knowns and known unknowns is:
- Known unknowns: we have no control over them. They’re external events controlled by seemingly random forces.
- Unknown knowns: we have full control over them. They’re our decisions.
For example, in a game of chess we need to decide on our next move, which we want to be as good as possible. Until we’ve decided on it, it remains unknown. Once we’ve decided, it becomes known. So it’s an unknown known.
Some examples of decisions (unknown knowns) in retirement planning are:
- Level of discretionary spending
- Amount of savings into a pension plan
- Whether to buy an annuity or to draw down from a retirement fund.
Ensuring Your Retirement Plan Is Complete
Good financial advisors will instinctively understand these four categories of information. Of course they’re unlikely to use the same labels, but they’ll treat each category differently when assisting their clients with retirement planning. Just recognising the four categories doesn’t guarantee good results, but doing so is an essential part good planning.
How do online retirement calculators measure up? Unfortunately, the majority don’t measure up well at all. Most calculators treat everything as known knowns. For example:
- Investment returns have inherent uncertainty (known unknowns), but are treated as constant.
- No explicit provision is made for contingency to cover the unexpected (unknown unknowns).
- Users guess their own strategy for things like discretionary spending and savings (known unknowns).
Such calculators are far too simplistic to yield useful results.
There are a few calculators that take uncertainty into account. But there’s only one that fully takes all four information categories into account. Of these, the unknown knowns category is the most challenging, since this requires some form of artificial intelligence to help optimise users’ decisions.
The Intelligent Financial Calculator
EvolveMyRetirement® is the Intelligent Financial Calculator. We specifically designed it with all four categories of information in mind. It’s the only free-to-use retirement calculator that not only recognises uncertainty, but can also optimise the decision-making process.