Dangerous magic in your retirement plan
NEW YORK (Reuters) - Don't look now, but your retirement savings plan may not be as ironclad as you think. It may even include some magical thinking.
That's because every retirement calculator features an "annual rate of return" that savers typically are asked to plug in for themselves. And the hard truth is, no one really knows how well their investments will perform in the future -- and that makes all our detailed retirement calculations seem kind of futile.
But here's something we do know: The good old days, when savers blithely counted on their retirement savings growing 7 percent or 8 percent or even 10 percent, year after year after year, are likely gone. In the New Normal, cautious investors are learning to revise their expectations downward.
People like Louis Berlin, for example. The Miami insurance salesman was one of those who piled into risky assets in the late 1990s, and thought he could rely on hefty annual stock gains.
"I thought those ‘90s rates of return were going to carry us all through, and then we had a Lost Decade," he says.
After losing hundreds of thousands of dollars in the dot-com bust, he settled on a new rate of return for the future: 3 percent. Or, when he's feeling a little devil-may-care, 4 percent.
"When people start expecting 8 or 10 percent a year, that's when they get into real trouble," says the 58-year-old, who currently keeps about half of his portfolio in equities. "People get carried away on the high side, and when reality hits they're unprepared. Then you have a whole decade of missed returns you have to make up."
REALISTIC OR MAGICAL?
So what's realistic when it comes to portfolio returns, and what's essentially magical thinking? After all, you have to put some number into those retirement calculators, even if it's just a back-of-the-napkin approximation.
A couple of basic building blocks: According to Irvine, California-based Index Fund Advisors (IFA), 86 years of data reveals the long-term return of the Standard & Poor's 500 index to be 9.78 percent annually, while long-term government bonds average 5.73 percent.
That's a good place to start, and then you can start refining from there, depending on your particular asset allocation.
Just remember that whatever figure you jot down will have an enormous effect on determining how much you need to save right now.
"Very few people get it right," says Elle Kaplan, a financial adviser and founding partner of New York City's Lexion Capital Management. "The assumptions you make are critical to your long-term financial health, and what I fear is that people are making inaccurate assumptions. They're too rosy, and by the time retirement comes around there's not too much you can do about it."
Even among financial professionals, there's a wide range of expected rates of return. For its sample pre-retirement balanced portfolios, Baltimore fund shop T. Rowe Price plugs in 7 percent annual returns, pre-retirement. Vanguard uses 6 percent for a long-term, balanced portfolio.
In a recent research paper titled "How Much to Save for a Secure Retirement," Boston College's Center for Retirement Research analysts used a slim 4 percent. That might be overdoing it on the cautious side -- but if being ultra-conservative prompts you to save even more, then that's not a bad outcome. Better to end up with too much than too little.
But as the old joke goes, ask 10 economists the same question, and you'll get 11 different answers. That said, there are some guiding principles that can help you arrive at your own answer.
Here are some tips for determining a projected rate of return that could work for you:
* Use long-term averages as a guide, not an absolute. If your time horizon until retirement is lengthy, with decades to go, then it's reasonable to expect a reversion to the mean and that your returns will be close to those numbers provided by IFA - almost 10 percent for equities and a little over half that for long-term bonds. The shorter your time horizon, the less helpful those figures are as a guide.
* Estimate on the low side. That's because it's not realistic to expect to benefit fully from the rise of various asset classes. As behavioral economists will tell you, investors -- guided by our emotions -- tend to buy high and sell low. That's why financial adviser Jeffrey Romond of New York City's St. George Financial Partners prefers to use a modest 5 percent as a guide for annual portfolio returns.
"The biggest issue is not the markets or the economy," he says. "It's us, as investors, moving in and out of various asset classes at the wrong times."
* Use subtraction as well as addition. If your projected rate of return leads to a retirement total of a million bucks, say, it's not as if you'll end up with a million bucks in today's dollars to play with. There are a couple of portfolio-killers that eat away at that sum: Inflation and taxes. And given the nation's recent trend toward money-printing and debt accumulation, it's reasonable to assume that those figures will be ticking up in years to come.
"They're easy things to overlook, and many retirement calculators don't even include them," says Kaplan. "But don't underestimate their importance, because they're going to take a bite out of your returns and erode your purchasing power."
Budget conservatively with your expected rate of return, and you'll end up like Louis Berlin -- confident, but not cocky about your assets as you head into your retirement years. After all, once you get there, you're still likely to have a couple of decades of projecting to do.
(Editing by Linda Stern and Andrea Evans)