Calculating Risk and Investing Wisely

Understanding Rate of Return For Retirement Planning

Understanding Rate of Return For Retirement Planning

Planning for retirement would be far easier if it could be reduced to a mathematical certainty.  Unfortunately, there are some variables even the most skilled financial planner doesn’t know.

Rate of Return in Investment
Source

An overriding concern of many investors is running out of money in retirement.  In order to answer this question with total confidence, you would need to know the following:

  • The date when you (and your spouse, if your calculation includes others) will die
  • The rate of inflation during your retirement
  • The retirement rate of return you will earn on your investments 

Using averages is the best you can do for the date of your death and inflation rate.  

A recent report from the Center for Disease Control shares that life expectancy at birth for women in the United States is 79.1 years; for men, it’s 73.2 years.  The Social Security Administration has a calculator that permits you to enter your gender and date of birth.  It will show the average number of additional years you can expect to live.

Financial planners can take a similar approach to inflation.  The average rate of inflation in the United States was 3.29% from 1914 until 2022. 

Using averages can lead to misleading conclusions.  If your retirement planning assumes you will live an “average” lifespan but you outlive those expectations, you may run out of money for those “above average” years.

While the average rate of inflation may be only 3.29%, the current rate is 7.7%.  You don’t know whether this is an aberration or if the average inflation rate over the next decades will be higher or lower.

Similar issues arise when calculating the rate of return on investments.  Even a small difference can seriously impact how much you need to save for retirement.

Approaches to calculating the rate of return 

There are different approaches to calculating the rate of return on your investments in retirement.

Assume a rate of return

You can simply assume a rate of return, but doing so involves consideration of both the assumed rate of inflation and your investment period.  It’s also important to understand the difference between real and nominal returns.

Real return is earned on an investment after accounting for taxes and inflation.  Nominal returns don’t take taxes and inflation into account.

If your actual return on investments is 10%, but inflation is 3%, your inflation-adjusted return will be reduced to 7%.

Between 1960 and 2009, the inflation-adjusted compound growth rate for the S&P 500 ranged between 5.07% and 7.52% over a 30-year period.  It would not be unreasonable to use somewhere in this range, like 6%, as your assumed rate of return.   

The longer your retirement funds can remain invested—especially prior to the time when you need to start making withdrawals—the greater your ability to take more risk, which will increase your expected returns.

Linear vs. Variable returns

When you use an assumed rate of return, either real or nominal, you are relying on a single fixed rate, reflecting your average return for the entire length of your projected returns.

Using a linear return has serious limitations.

The average return of the S&P 500 since 1928 is 10.22%.  But an examination of actual yearly returns shows a wide variability. 

In 2018, the index lost 6.24%, but in 2021, it gained 6.89%.  For the decade from January 2000 through December 2009, the S&P 500 index had an annualized return of -0.95%.

Because of the lack of consistency of linear returns, many financial planners calculate variable returns using a Monte Carlo analysis.  A Monte Carlo analysis is a computer-generated simulation used to estimate the probability of different outcomes, considering multiple variables.

A Monte Carlo analysis calculates a “probability distribution” for any variable, like the rate of return, that is uncertain.  It then “recalculates the results thousands of times over, each time using a different set of random numbers pertaining to each variable, to produce a vast array of outcomes that are then averaged together.”

A Monte Carlo analysis can calculate the probability of success (defined as not running out of money) at any age or set end date.

While a Monte Carlo analysis can be a reliable tool in calculating the rate of return for retirement planning purposes, it has its limitations.

  • Monte Carlo software varies in quality, with some offering more inputs than others.  
  • The methodologies the software uses can vary.
  • Monte Carlo uses past performance to predict future results.  It doesn’t have predictive ability.

A Monte Carlo analysis might not adequately account for the sequence of returns risk.  This is the risk derived from the order in which your investment returns occur.  

An investor who retires in a down market, which continues to decline in the early years of retirement, can deplete a retirement portfolio more rapidly than another investor who retired in a bull market that persisted during the early years.

Although Monte Carlo simulations have shortcomings, many planners believe using them is superior to other means of calculating the rate of return in retirement planning.

To learn more about the rate of return planning, consult with a registered investment advisor today. 

Similar issues arise when calculating the rate of return on investments. Even a small difference can seriously impact how much you need to save for retirement.

Trending

Understanding Rate of Return For Retirement Planning

Understand the basics of the retirement rate of return on your investments in this article.

Pros and Cons of Paying Off Mortgage Before Retirement

This article explains the pros and cons of paying off your mortgage before retirement.

Investment Options for Your Retirement Planning

TriangleBackgroundTriangle
Image
Financial Security
Starts here