what is a reasonable rate of return on retirement investments?
Most financial advisors are likely to tell you that over the long run equity investments such as stocks have provided superior performance. However, any advisor worth his or her salt will also tell you that projecting past performance into the future can be dangerous to your retirement savings plans.
The reason for this is that along with higher returns comes greater risk. While the stock market has outperformed investments such as bonds or certificates of deposit (CDs) over the long haul, in any given year they are typically subject to greater volatility. This means that while you may not make as much in these more conservative investment asset classes, you likely won’t lose as much either if things don’t go the way you planned – at least in the short run.
Market Returns are Variable
The key mistake retirement investors make is to assume that a current market trend, whether long or short-term, will continue indefinitely, or at least into retirement. For instance, if your mutual fund portfolio has earned 8% a year on average for the past 10 years, why not assume that it will continue to earn this amount once you retire? The reason is that, historically, returns from both the equity and fixed-income (bond) markets have varied significantly over longer periods of time.
Leaving aside catastrophic economic conditions which could result in the stock market declining over a 10-year period, even an extended time of lackluster economic growth could cause the market to produce a lower return than the 8% you were anticipating. If that return was 4% per year it would result in 50% less income from your savings, assuming you were withdrawing the full amount of growth each year.
Think about what this means. For instance, if you expected to generate $80,000 per year in retirement income from your retirement savings and instead only received $40,000, how would that affect your lifestyle? The answer is that it would likely have a significant impact, unless this money was just a small part of your overall retirement income. For most people, the income they generate from their retirement savings is likely to play an important part in covering their retirement expenses. If that income dropped by half, the consequences would likely be severe.
How severe? After the last market crash in 2008, there were numerous tales of people who were either forced to delay their retirement or leave retirement and return to work if they had already retired due to the devastation the downturn wreaked on their investment portfolios.
Stress Test Your Retirement Savings Portfolio
How can you avoid encountering such a scenario in your own life? The answer is to be cautious in forecasting future investment returns when doing retirement planning. For instance, if we use the prior example of a portfolio which had generated 8% a year before retirement only generating 4% in retirement, we can see that an individual who had planned for such an eventuality by only needing 4% from their savings to live comfortably would be in better position than someone who had based their retirement lifestyle on continuing to earn 8%.
The point here is that when making retirement income plans, you should always consider worst case scenarios. Performing this type of “stress test” planning enables you to avoid being unable to retire comfortably or being forced to delay your retirement due to unrealistic expectations as to how your retirement savings portfolio will perform when you retire.
When performing a stress test, one way to proceed is to use simple straight-line calculations as to how much retirement savings you will amass given a certain amount of contributions and a specified rate of growth. There are a number of online compound growth calculators you can use to determine these figures. However, if you want to perform a more sophisticated analysis of the likelihood that your retirement savings and investing strategy will provide you with the desired results, consider using financial planning, or finplan, software to help you with the complex calculations involved in this type of analysis.
Monte Carlo Analysis and Financial Planning Software
Financial planning software can be a powerful tool for performing a stress test on your retirement planning assumptions. Whether in conjunction with your financial advisor or on your own, you can use this software to display in graphical form the effect various levels of market returns would have on your ability to generate enough funds to support your desired level of retirement income.
The leading financial planning apps utilize a projection methodology called a Monte Carlo analysis which looks at a range of possible returns based on past returns from particular asset classes to give you a percentage chance readout of how likely your retirement investment plan is to achieve your financial goals. Unlike a straight-line projection, which simply assumes that future performance will continue unchanged into the future, this type of analysis takes into account past performance variability to give you a more nuanced picture of how your portfolio is likely to perform.
For instance, as related above, simply assuming current market trends will continue can result in a retirement income shortfall if those trends reverse or simply become less robust. If you use straight-line return assumptions when planning for retirement, there is no way to know how likely your plan is to work – short of waiting until you actually retire, by which time it will be too late. On the other hand, a Monte Carlo analysis can help you manage your retirement expectations and make changes prior to retirement based on the figures generated by the software running these projections.
For instance, a Monte Carlo analysis might show that your current retirement investing plan has a 50% chance of reaching your objective, providing you with an early warning that your strategy could very likely fall short. This enables you to make changes to your plan, for instance setting aside more funds for retirement or changing your portfolio asset allocation, to increase the chances that you will be able to reach your savings goal.
To learn more about some of the top retirement planning software apps and their functionality, this article can be a good place to start. If you don’t want to purchase the software yourself and you are working with a financial advisor, you can ask the advisor if they use such software, as many advisors either own software of this type themselves or have access to it through their firm.