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What makes me unique as a financial advisor is that I focus on working with Generation X clients. Unlike Baby Boomers, my client base is just beginning to save aggressively for retirement, either because they are just entering their prime earnings years or are finally done with educational obligations to their children. They are still at least fifteen and up to thirty years away from making work a voluntary activity, which means that they are nowhere close to having a fully formed retirement.
As a result, there is a heavy reliance in projections in the retirement planning process. I look at what the client has already saved, what they plan on saving going forward, and then come up with an estimate of what their portfolio will look like when the time comes to dial back on their working lives. Where this becomes problematic is that thanks to compound interest and the time value of money, small changes in assumptions surrounding investment returns will have a substantial impact on the projected size of the retirement nest egg.
The bottom line is that having good, realistic assumptions is extremely important when you’re a long time from retiring. The further out you are, the more important those assumptions become. On one hand, you’re setting yourself up for heartbreak and failure if you assume that your investments will return twelve percent a year. At the other end of the spectrum, assuming that your investments will earn nothing is too pessimistic and leads to unnecessary stress and feelings of hopelessness.
There is a balance, however. You want to assume high enough returns that make it worthwhile to save, but also want to be conservative enough in those returns where failure to meet those high assumptions isn’t catastrophic.
The question then becomes, what are good assumptions? The first place to look is at historical returns for stocks and bonds, the two most common asset classes. (Yes, I know I’m excluding the effects of inflation and ignoring a lot of asset classes including small company and international stocks but my goal here is to keep it simple!) From 1928 to 2012 the stock market as represented by the Standard & Poors 500 had an average annual return of 9.31%, while bonds as represented by 10-year Treasury Bonds had an average annual return of 5.11%. It’s important to remember that both stocks and bonds go through cycles where they can diverge from these averages, either on the positive or negative side. To be on the safe side, I’m going to assume that the Standard & Poors 500 only does as well as it has the last 10 years, which was 7.02%, and that 10-year Treasury Bonds only return their current yield of 2.61%.
Using these numbers with a default asset allocation of 60% stocks and 40% bonds would give us a range of returns between 7.62% and 5.24%. Most professionals that I know assume a rate of return of return between 5%-9% which varies with how much risk the client wants to take and the advisor’s personal views of what asset prices, economic growth, and interest rates are going to do in the future.
The outlier on projected returns is a certain radio personality who has consistently and repeatedly projected 12% returns going forward. While stocks have from time to time returned that much for multi-year stretches, it is unreasonable to believe that they will do this well going forward. Assuming 12% returns will greatly inflate the size of nest egg and/or reduce the recommended amount of money people need to save. If your investments don’t return 12% a year (which I don’t think they will), the effects of this over-optimistic projecting and under-saving on your retirement will be disastrous.
What I do in working with clients is to go with is 7.2% returns for two reasons: 1) prior returns and current price levels support this assumption; and 2) after factoring in compound interest, a 7.2% rate of returns results in an investment portfolio doubling every ten years which is easy for clients to understand.
I also work backwards from how much they want to have and when they want to have it and establish ‘checkpoints’ along the way. If the portfolio doesn’t hit a checkpoint, we can recognize a potential shortage in retirement monies at an earlier point in time and take the necessary action then. The earlier a shortfall is caught, the less dramatic the remedy is going to be. Ultimately there are only three cures for falling behind on retirement savings: spending less, saving more, and working longer.
What assumptions are you using for your retirement? Where did they come from? How are you holding yourself accountable?
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