In retirement planning, it’s your real return that matters

If you’ve ever used one of the many online retirement planners, they always ask you to enter your assumed rate of return on your investments. Many people probably stare blankly into the computer and just make a guess. That return assumption, however, is probably the most important part of your retirement planning equation. So how do you pick a number that’s reasonable?

A good start is to look at historical market returns, since that’s basically all we have to go on. For stocks, the long-term total return is about 10 percent annualized over the last 90 years. And for intermediate term bonds, the return is around 5 percent. But those average returns need to be put into context. One of the primary things to understand about long-term returns is that they include inflation. As you know, salary increases above inflation are what really impact your lifestyle, and this same issue applies to your investments.

For instance, if your household income is $100,000 and inflation runs 5 percent for the year, you have to earn $105,000 next year just to buy the same stuff you could buy this year. But if inflation was 0 percent, then any raise you got would actually increase you spending power. Thus, a 5 percent raise when inflation is 5 percent, is less valuable than a 1 percent raise when inflation is 0 percent. In this example, the difference between your raise and inflation would be called your “real income” gain. Again, this same concept also applies to your investments.

Inflation over the long term has run at about 3 percent, thus the 10 percent return from stocks really only translates into about a 7 percent real rate of return. And the 5 percent gain from bonds only translates into about a 2 percent real rate of return. Because you have no idea what inflation will be in the future, when doing retirement planning, a good rule of thumb is to con- sider using a “real rate of return” assumption. That means a return net of the inflation number. This will allow you to translate those future retirement numbers into today’s dollars.

For instance, if you have $500,000 of retirement savings in stocks and it grew at 7 percent a year for 20 years, it would be worth about $1.9 million in today’s dollars. Then you can ask yourself, if I had $1.9 million today, could I retire?

If you were invested all in bonds, you would have to reduce your real rate of return to about 2 percent. In that case, your $500,000 would be worth about $743,000 in today’s dollars. And again you could ask yourself if you could retire on that today.

If you have a blended portfolio of say 60 percent stocks and 40 percent bonds, the way to estimate your real rate of return for your portfolio is to take the 7 percent for stocks and multiply it by 0.6 and take the 2 percent for bonds and multiply it by 0.4. Add those two together and you’d have an estimate of a real rate of return of 5 percent.

With all rules of thumb, however, there are exceptions. And today, you probably have to adjust these real rate of return assumptions because of the unusual markets we are in. This will build a margin of safety into your retirement projections.

While we know long-term bond returns have outpaced inflation by about 2 percent, today bond yields are only outpacing inflation by about 0.7 percent. And for stocks, we’ve had a long period of above average real rates of return. Because returns tend to revert back to their averages, you should consider dropping the stock real return by at least 1 percent. If you do that, then a blended stock/ bond portfolio real return comes in closer to 3.9 percent. Plug these numbers into your retirement planner and you’ll have a better idea of what your “real” retirement might look like. While this real return sounds low, it’s likely a fair estimate in today’s financial world.

If you don’t like what you see, there are two primary things you can do. The first, and safest, is to increase your savings rate. If you add more money, you can help compensate for the low real rates of return. Second, if you have a lot of bonds, you can consider allocating more of your money to a diversified portfolio of stocks. This in theory should increase your long-term real rate of return. But, it will add more volatility and uncertainty to that return. Or you can do a little of both, which might be the prudent choice.