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Written by J.P. Wicklein
When discussing how much money you will have at retirement age many financial articles assume that you will attain an average annual return of around 10%. This assumption is misleading for two reasons.
Asset Class Diversification
The assumed 10% annual return is based on a portfolio of 100% stocks. Conventional wisdom states that as you draw nearer to retirement you should reduce your stock holdings and increase your exposure to bonds and cash. (You would be wise to do so.) Historically, stocks provide better returns than either cash or bonds over the long term. As you near retirement, however, you will no longer be dealing with the same long term period that you were when you started saving for retirement in your 20’s. As a result, the assumed 10% return that a portfolio of 100% stocks will provide is no longer correct as you begin to sell your stocks in favor of cash and bonds. For example, let’s assume you save $5,000 every year toward retirement from the age of 25 to 65. If your portfolio were 100% stocks the entire time, using the 10% assumption, you would have $2.4 million by age 65. However, if over time you gradually diversified your portfolio (ending with 20% stocks, 40% bonds, and 40% cash) by the age of 65 you would only have around $1.1 million. Diversifying your portfolio would reduce your average annual rate of return from 10% to around 7.5%.
Inflation
Okay, you just realized that you will only have 45% as much money when you retire as you initially thought ($1,100,000/$2,400,000). Let’s carry your 7.5% annual rate of return a little further. You are 25 years old and just realized that you will have $1.1 million for retirement. As the years roll by from age 25 to age 65, however, the purchasing power of your dollar will erode as inflation takes its toll. The $1.1 million viewed at age 25 won’t buy you nearly as much as it will when you are age 65. In order to get an accurate picture of how much money you will have in retirement you need to account for inflation. Over the long term, inflation averages 3% per year. This means that instead of earning an average of 7.5% annually you are really only earning 4.5% annually. What does inflation do to the $1.1 Million? Adjusted for inflation when you retire you will only have $500,000.
Bad Assumption, Big Impact
After factoring in asset diversification and inflation into your annual rate of return the assumed 10% is actually only 4.5%. The $2,400,000 you thought you had for retirement is really only $500,000. So why don’t many financial advice columns tell you this? I suspect it is just easier to tell readers 10% than trying to explain asset class diversification and inflation. It’s not just financial advice articles that make this mistake. Many online retirement calculators don’t account for asset class diversification or inflation, either. So next time you decide how much to save for retirement remember that the 10% return that you may think you’re getting is really much, much less.
6 responses so far ↓
1 Roger // Nov 9, 2008 at 4:56 pm
Wow….I’m in trouble. Good article. I figured a 10% return was too good to be true.
2 11-17-08 Twenty-Something Finances-Carnival // Nov 17, 2008 at 7:09 am
[...] Wicklein discusses whether a10% Annual Return is Unrealistic posted at Financial Fellow. I agree and usually use 8%. Dave Ramsey suggests 12%, Oy [...]
3 Colleen // Dec 27, 2008 at 5:36 pm
I’ve been meaning to reply to this!
First… a more conservative estimate for an all stock portfolio is 7-8%. (Better to underestimate and overdeliver) Balancing your portfolio towards growth and income as you near retirement is a good idea. However, the example that you use is far too conservative (ending with 20% stocks, 40% bonds, and 40% cash). That individual will quite possibly run out of money (unless they are very, very wealthy) with only 20% in equities due to inflation. For most people, it’s important to develop a strategy for your portfolio that will generate enough income in retirement while still growing. However, not all people need to generate income! Those retired with pensions can afford to be more aggressive with their investments (if their stomachs can swallow it) because they have a stream of income. Everyone is different…
As far as the example on inflation… the point is correct, however, the person will still have 1.1 million dollars (provided that your math is correct) that will compound over time. To say that the person only has 500k is really not accurate because they have 1.1 million. It may not buy them as much, but it compounds much faster than 500k. Right?
Bottom line… what the downturn of 2008 has taught me is to start investing as much and as often from a very early age! Time in the market is what matters the most. And… find a good financial advisor that you trust. You may pay them for the help, but it’s likely that the your overall financial situation will be better as a result.
4 Financial Fellow // Dec 29, 2008 at 10:54 am
Colleen -
I agree that 7-8% is probably a more appropriate estimate. I used 10% in this example since that is what is traditionally thrown out as the long term, annual stock market return. I agree that my ending portfolio mix is probably a bit conservative. That said, since I’m using the 10% annual return assumption (instead of 7-8%) that should more or less make my conservative portfolio be more aggresive. Which would ultimately result in returns that are still around 1.1 million - not 2.4 million.
Good point on the inflation compounding at the 1.1 million instead of the 500k. That will make the balance a bit more.
Overall, though, I think we would both agree that the fundamental statement of the above article is true: Assuming a 10% annual return isn’t really valid. That, and all this really does is put even more emphasis on the need to invest as much as you can as early as possible.
Thanks for your comments!
John
5 Monevator // Dec 30, 2008 at 7:35 am
There’s a strong case for saying investors should stay overweight in defensive, dividend paying stocks when they reach retirement age these days.
Not fully invested by any means, but switching to a fixed income portfolio at 65 could look foolish with people routinely living to 85 or 90 years old.
Always good to question assumptions though. You might want to consider fees, too - lots of investors will find a chunk of their 7-10% eaten up by unearned fees from market-tracking actively invested mutual funds.
6 Financial Fellow // Dec 31, 2008 at 11:01 am
Monevator -
Good point on the fees. At some point in the near future I’ll be doing an article on actively vs. passively managed funds. (Mutual Funds vs. Index Funds).
Thanks for the comments!
John
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