One of the most crucial parts of creating a financial plan is determining the expected return rates on your investments. How much income those investments will be able to generate both before and after retirement will be integral to determining how long your savings may last, but you have to be realistic. To calculate the returns on your investments, most calculators and planning tools allow only one return rate to be entered for all years. Unfortunately, this assures that the results will be skewed, and not in your favor (explained below). For this reason, if you have the opportunity to create a financial plan using varying return rates for each year (as you do with TCRP), be sure to take advantage of it!
When creating a financial plan, most people default to using a single return rate for all years because they believe (correctly) that there is no way to accurately predict decades of future investment returns, and because using an average rate seems like it should accurately account for the highs and lows of likely annual returns (incorrect). It's also much easier/faster to copy/paste the same rate for all years rather than to enter each year separately. Unfortunately, speed is not the goal, and taking a few extra minutes to get things right is well worth the effort.
To arrive at an initial return rate, the historical average return of the S&P 500 is a popular choice (9.06% over the past 20 years). 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 a longer time frame? The results for each time period vary greatly. Do those results match your own personal results for the same time frames? Your actual results may be very different from the market as a whole. Will you adjust your risk tolerance and/or investing style as you age? If so, using an identical rate for all years won't account for that. Also, forecasting varying annual returns, even within a tight range, rather than using a consistent rate for all years, can produce vastly different results. Using an average return rate for all years of a financial plan simply does not produce the same result as using a range of varying annual rates. Consider two examples:
• The average return for the S&P 500 for the three years from 2000 to 2002 was -14.36%. Even with double digit gains in 2003 (28.68%) and 2004 (10.88%), averaging 20%, plus gains averaging 10% over the next two years, you wouldn't have regained your balance from the beginning of 2000 until 2006, which would be a 0% return over 6 years. The average return for those 6 years was just over 4%.
• In 2008, the S&P 500 dropped 37%. Even with gains of 26.46% in 2009 and 15.06% in 2010, it still took an additional two years of positive returns to re-coup the 37% loss from 2008. The average return for 2008 - 2012 was 4.5%.
This emphasizes two important points -
1) It can take multiple positive years to offset a single negative year.
2) In the past 20 years, the S&P 500 has had 4 years of negative returns (20% of the time).
3) The combined average return of all years in a time period does not accurately reflect the net result of calculating annual returns individually in the same time period.
Creating a financial plan that uses an equal, positive return for every year and/or neglecting to plan for at least a few negative returns over a long time frame, even mildly negative returns, simply isn't realistic and won't result in a reliable financial plan.
So how should you proceed? 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. This will reflect your investing style. 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 either the S&P 500 average return rate for the past 20 years (9.06%), or your own actual return rate. Then modify that average return with random annual results that are slightly higher and lower than the average, within a fairly small range. Make sure to include a few mildly negative years (one every 5 years?). How different are the results?
Here's what happened when I tried it:
Scenario 1) Starting with $1M (a nice round number) and applying a 9.06% annual return rate over 20 years, I ended up with $5.66M.
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 1 entry below 5%, 9 entries between 6% - 9%, 7 entries between 10% - 15%, and 3 entries between -2% and -5% (1 fewer, and less severe, negative years than actual S&P results). After 20 years I ended up with $3.99M.
The difference in the results of over $1.6M (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 -5%. 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 $4.22M, or less than 10% variance to my random entries. Total luck, but not to be easily dismissed.
Your plan will benefit from conservative realism more so than from 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.