What rate of return should you assume for your retirement plan?
Every retirement plan requires making some key assumptions. One of those important assumptions is the rate of return you are going to get on your investment portfolio.
In fact, I liked the topic so much I thought I should give my two cents on the issue.
Using past performance as a benchmark for future performance.
It’s nearly impossible to predict the future so more often than not we use past performance to try and create some assumptions for the future. In Nelson’s article, he sites some data on the S&P 500 during some of the worst periods in history.
Despite that history, the worst return is only 8.67% which is why he likes to use 8 % to 10% for his personal projections.
The problem with using historical returns is you can come up with whatever number you want depending on what time frames you use. I call this snapshot performance. Snapshot performance can be a real problem in trying to use past returns to predict future returns. A good example of this is the 10 year period from 2000 to 2010 where stock market returns were not any better than low interest GICs.
Do people really hold for 20 or 30 years?
The other problem with these snapshot returns is who holds for 20 or 30 years anymore? Times change too much and too fast which makes it increasingly difficult for most investors to implement that the traditional buy and hold strategy. Buy and hold forever is just not as applicable as it once was.
A case of bad timing can ruin everything
The real problem with investing for retirement is the stock markets can do really unpredictable things when you may not want them to happen. I’ve often said the stock market is not predictable or controllable so the variability can be really destructive to the timing of people’s retirement. Just think back to the last 10 years and how the stock market delayed many people’s retirement. The stock market hit retirees hard during severe corrections.
End date bias can change a portfolio’s return dramatically within months, weeks and even days. The last thing anyone wants it to retire just as the stock market takes away 20%, 30%, 40% or more. Projecting rates of return is essential but the biggest problem is the risk of the markets can change that return very quickly – I call this the retirement risk zone. For more on stock market risk and retirement, check out an old article called 6 perspectives on why retirees need to be more conservative with their portfolios.
Project with multiple returns
In the end, whatever return you choose for your retirement projections will change. In other words, you are guaranteed to be wrong. Some people think it’s better to be conservative and hope for better. Other’s feel more confident about their investment abilities.
When I teach people about retirement planning, I always say that a retirement plan is dynamic and guaranteed to change. On that basis alone, I suggest people do their retirement projections using a minimum of 3 returns:
- Use a conservative number almost based on a worst case scenario. I often default to the risk free rate of return or the 3 year GIC rate.
- Then use an optimistic return. If we look at the stock market, it’s commonly thought that the stock market could produce 10% to 15% returns.
- Then use a balanced or realistic approach. Some call it average returns others call it the middle.
Be running three different projections, what you are going to see is the range of possibilities. For some people even running the conservative projection gets people to their goals. In that case, they have the comfort of knowing they do not have to take any risks.
Seeing multiple projections based on different rates of return helps prepare you for the future better because you can see different possible outcomes. The more variable your portfolio is, the more important it is to use a range or returns.