Every financial plan will require you to enter an investment rate of return for retirement savings. This is a critical piece of the retirement plan puzzle since it is a determining factor in how long your savings will last. It should not be glossed over. Calculators and less than robust planning tools only allow one entry for an investment return rate, and this is another reason why their results are skewed. But if you have access to a planning tool that allows for annual entries rather than a single average, take advantage of it. Because there is no way to accurately predict decades of future returns, most people default to using an historical average (the S&P 500 is commonly used as being representative of the markets as a whole). But the results of the overall market may not be the best information to use. Will you be looking at the past 5 years, 10 years, 20 years, or more? The results for those time periods vary greatly. Do those results match your own personal results for the same time frames? Your risk tolerance, investing preferences and actual results may vary greatly from the market as a whole. Also, forecasting both up and down years, even in a tight range, rather than a consistent average for all years can produce vastly different results. You may think that using an average return rate offsets a range of up and down results, but read on.
Consider the average return for the S&P 500 for the three years from 2000 to 2002 - it was -14.36%. Even with double digit gains in 2003 and 2004 you wouldn't have regained your balance from the beginning of 2000 until 2006, which would be a 0% return over 6 years. In 2008 alone the S&P 500 dropped 37%. Even with gains of 26% and 15% in the next 2 years, it still took 4 years to re-coup those losses. Since upward swings in returns for one year do not equally offset a similar downturn from a prior year, not planning for at least a few negative returns over a long time frame, even mild ones, is not realistic. It can take multiple years to offset a negative year, which is why an average for all years doesn't work. Life is not static so if you don't have to plan it that way, don't. While you can't foresee how financial markets will behave year by year, you can model your return rate to reflect your actual results over time. Start with your personal average return rate (not a market average) for the past 10-20 years. Then include random lower, higher, and even some negative return years to reflect a more challenging environment. You won't get it right by year, but that's okay. Including a variety of possibilities will be more realistic than using a flat rate. To prove this theory, create a plan using the S&P 500 average return rate (7.16%), or your own actual return rate, for the past 20 years. Then modify that average return with random annual results that are higher, lower, and even a few years that are slightly negative. How different are the results?
Here's what happened when I tried it:
Scenario 1) Starting with $1M (nice round number) and applying a 7.16% annual return rate over 20 years, you would end up with $3.98M.
Scenario 2) Starting with $1M, I quickly (so as not to overthink it) and randomly entered annual return rates for 20 years. I tried not to go to extremes. My entries resulted in 6 entries at the prior average of 7.16%, 6 entries between 7% - 15%, 5 entries between 0% - 7%, and 3 entries between -1% and -7% (2 fewer and less severe negative years than actual S&P results). After 20 years I ended up with $2.86M.
The difference in the results of over $1M (30% less than using the historical average) is significant, especially if you were counting on that money to last through your final years. Of course, this is only one example and random entries will produce random results, but note that I was keeping my entries within a realistic range of +15% to -7%. The point is that using a variety of return rates may prove to be more realistic and/or conservative than smoothing the results out to mimic an average historical return. Incidentally, if I started with $1M and use the actual S&P 500 results year by year for the past 20 years, I ended up with $2.98M - or very close to my random entries. Total luck, but interesting.
Your plan will benefit from conservative realism more so than hopeful optimism. You don't want to be part way through retirement only to find out that your results, and savings balances, are falling well behind your plan forecast. As Neil Armstrong once said, "If you're an inch off on landing, no big deal. If you're an inch off on takeoff, you miss the moon by a thousand miles." Make sure that your financial aim is focused on the best possible forecast from the start, as that will drive the accuracy of where you will land financially in retirement.