1) Why rate of return is important
Rate of return is the estimated rate that your investments will provide to you. There are simple returns and compounding returns. A simple return is found by dividing the incremental appreciation in the value of an investment by the investment amount.
For example, if you invested $1,000 into the stock market and it appreciated by $100, your simple return would be 10%.
Compounding returns on the other hand not only earn interest on the initial investment, but also earn interest on previous gains.
When planning for retirement, it is vital to accurately estimate what the rate of return will be on your underlying investments. If you miscalculate what rate of return you will earn, you can quite literally throw off your entire retirement plan.
For example, say that you are currently 30 years old and plan to retire when you are 65. You plan to invest $750 per month and estimate that you can earn a compounding return of 10% per year averaged out over a 35 year time horizon.
Using the assumptions above, you would have just over $2.4 million when you retire. However, what would that number look like if your actual return during that period was only 9% per year over the 35 year period? Although a percentage point does not seem like that much of a difference, you would now have just over $1.9 million.
Simply by overestimating your return by a single percentage point, you would now be $500,000 worse off. If you needed $2.4 million to retire, you would have to continue to work. This shows why it is vital to accurately estimate your anticipated rate of return when planning for retirement.
2) Your estimated rate of return will depend on your investments
This may seem like a 'no duh' point, but it is worth mentioning. As it relates to retirement, most investors build their portfolios by investing in either equities (
stocks), fixed income assets (
bonds), or more commonly a mix of both.
In general, stocks will provide a higher rate of return than bonds. You may be an investor who has a high
risk tolerance and a primary investment objective of growth. If the majority of your portfolio is in stocks, it may be reasonable to estimate a return that is between 8% and 10%.
The reason for this is that the stock market has historically averaged a return of around 10% per year over long periods of time. However it is important to understand that this average return may not show the actual return (we will look at this more later on).
On the flipside, if you are a more conservative investor whose investing objective is on preservation of capital, more of your portfolio may be in bonds. If that's the case, a return between 4% and 8% may be more accurate depending on the asset allocation between stocks and bonds in your portfolio.
3) Understand the difference between average and actual returns
As mentioned previously, the stock market has historically averaged around a 10% return per year over long stretches of time. This can be proven by looking at the S&P 500 index, which is commonly used to gauge how the stock market is doing as a whole as it tracks the 500 biggest US companies.
Many investors will simply look at the average return of an investment and use it as their estimated return for retirement. However, it can be dangerous to base your estimated return off of the average return of a particular investment whether that be an individual stock or bond, or investment fund like a
mutual fund.
The actual return of your investments may differ from the average return. Let's look at an example to prove this. Say that you invested $5,000 into a portfolio that was heavily weighted towards stocks. In year 1 the portfolio went up 20%. In year 2 the portfolio went up another 25%. In year 3 the portfolio went down 15%.
This would leave you with an average return of 10% over those three years (20% + 25% -15%)/(3). However, what was truly happening to your $5,000 during these three years?
1) Year 1 - In year 1 your initial $5,000 grew by 20% which would leave you with a balance of $6,000.
2) Year 2 - In year 2 your $6,000 balance grows by another 25% which would leave you with a balance of $7,500.
3) Year 3 - In year three your $7,500 balance went down by 15% would leave you with a balance of $6,375.
The total amount of money your account earned over the three year period is $1,375. Your actual return over the three year period is just over 7.6% per year ($1,375/3)/($6,000). This is a 2.4% difference when compared to the average return of 10% described previously.
Keep in mind that this is a very short time horizon, so it is not the perfect argument. The point here is that your actual return may end up lower than the average return of a particular investment which can cause you to miss your retirement goals as your actual return and estimated return do not line up.
4) Previous returns do not guarantee future returns
The previous returns of investments do not guarantee future returns. This is vital to understand when estimating what rate of return to use for your retirement. In fact it is so important that mutual fund companies are required by law to make this exact disclosure when offering shares to the public.
As mentioned prior, if you overestimate what rate of return you will earn, your retirement picture will not look as pretty. For example, say that you head over to
Morningstar to do some investment research and find a mutual fund that looks quite appealing.
Say that the fund has been in existence for 5 years and is primarily invested in stocks. Over the past two years the fund has provided a 12.5% and 13% return respectively. This can easily entice investors to buy shares of the fund as these returns are higher than the average return of the market.
However, the data shows us that most investments (even those managed by professional fund managers) fail to beat the performance of a benchmark index.
SPIVA scorecard data found that 88% of actively managed mutual funds (those trying to beat the market) failed to do so over a 20 year period.
Now to be clear, there are investments that will beat the market over the long haul but they are less common and may be hard to identify. As you estimate your rate of return for retirement, do not get enticed by above average returns from particular investments.
5) Don't forget to factor in fees, taxes, and inflation
Fees, taxes, and inflation all have the potential to eat away at your return so it is important to factor them in when planning for retirement. Fees are the costs that you will pay to buy, sell, or own your investments and typically come in the form of a commission, sales charge, or expense ratio.
Although you may incur commissions or sales charges, the primary fee you need to pay attention to is the expense ratio. An expense ratio is a fee charged by a fund company to compensate fund managers, as well as pay for administrative and marketing costs.
Expense ratios are charged as a percentage based fee. There are a few reasons that you should pay attention to expense ratios when estimating your rate of return for retirement planning purposes. First, many investors who are saving for retirement will do so through funds like
index funds and mutual funds.
These are common investments offered through 401(k)s and IRAs which many investors use to save for retirement. Since most investment funds charge an expense ratio there is a high chance that if you are saving for retirement you will end up being charged an expense ratio.
Secondly, you should be aware of expense ratios as they will directly lower your rate of return. For example, say that you invested in a range of equity index funds through your 401k and anticipated a rate of return of around 9% per year.
However, say that the expense ratios of these funds were 0.25% per year. This means that instead of getting a 9% return, your true return will only be 8.75%. If you are looking to boost your rate of return for retirement, you can look for funds with low expense ratios as long as the investments make sense for your individual needs as an investor.
The second thing that can eat away at your return is taxes. As mentioned before, many investors save for their retirement through retirement accounts like a
401k or
IRA. The contributions and gains that you make in a 401k or IRA are not subject to taxes until retirement.
For this reason, you do not have to worry about taxes eating away at your return in a 401k or IRA during the years you contribute to these accounts as they provide tax free or tax deferred benefits depending if it is a Roth or Traditional account.
However, if you are saving for retirement through a taxable
brokerage account, you should pay attention to the tax implications. You may have to pay taxes on dividends or interest received from bonds that you own. You will also be subject to
capital gains tax if you receive a capital gain distribution from one of your investments or sell shares of your investments.
If you plan on saving for your retirement through a brokerage account, you simply need to be aware of the potential tax implications of investments within the account as taxes will eat away at your estimated rate of return.
Finally, inflation can eat away at your estimated rate of return. The average rate of inflation historically is somewhere in the range of 1.5% to 4% per year. Inflation is sort of an invisible cost at first as it does not come out of your portfolio like fees and taxes right away.
For example, say that you had $10,000 invested in a stock portfolio that went up 10%. You would now have $11,000. However, say that inflation was at 2%. This means that your true return was closer to 8% which would leave you with an inflation adjusted amount of $10,800.
Inflation is normal in some sense so it is not something that you need to panic about as long as the inflation is not too high. You simply need to factor inflation into your retirement plan and estimated rate of return that you will earn as you invest.
6) It is best to use a conservative estimate
Hopefully at this point you have gathered that it is usually best to be conservative when estimating what rate of return you should use for your retirement. If you are conservative with your estimate you will not be disappointed in a conservative return, and will be pleasantly surprised if you get a higher return.
On the flipside, if you overestimate your return and end up with a lower return than anticipated, your entire retirement plan can be derailed. Let's walk through an example that can help you think through how to estimate your rate of return that you should use for retirement.
Dan is a 25 year old who is starting to save for his retirement. Since he is young his investment objective is growth as he has an aggressive risk tolerance. For this reason, he decides to invest in an array of mutual funds that primarily invest in stocks through a
Roth IRA.
He anticipates that the average return for these mutual funds is going to hover around 10.5% per year averaged out over a long stretch of time. However, Dan is smart and understands that the actual rate of return may differ from the average rate of return.
For this reason, Dan anticipates that the actual return will be closer to 10%. Additionally, Dan factors in the expense ratios of these mutual funds which are 0.25%. This brings his return down to 9.75%. Finally, Dan estimates inflation will hover around 1.75% per year.
With all of these factored in, Dan estimates his rate of return that he will use for retirement at 8% per year. Since Dan is investing through an IRA, taxes are not going to reduce his return. This is an example of how you can think through estimating your rate of return that you should use for your retirement.
The bottom line
The bottom line is that rate of return is an important part of retirement planning. It will dictate how much money you have in retirement based upon how much you invested, as well as when you may be able to retire.
There is no way to perfectly predict what rate of return your investments will earn. However, you can do your best to estimate it by considering your investments, fees, taxes, and inflation. If you need help estimating what rate of return you should use for retirement, it is a good idea to work with a
financial advisor.
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