Retirement Investing: What’s a Reasonable Rate of Return?
One the many important decisions as you transition into retirement is: “How should I invest for this new chapter of life?” If you are reading this article, there is a good chance you are a prudent saver who has been saving and investing throughout your career. Now you need to figure out your retirement investing strategy. In other words, how will you invest your accumulated savings to maintain your lifestyle (or even improve it) once you no longer need to work for a living.
Of course, investing in retirement doesn’t just mean stashing money in an interest-yielding savings account and hoping to live off the interest. That strategy has been shown not to work well because it ignores unpredictable future interest rates and inflation. Retirement investing is a bit different than investing during the accumulation phase of your financial life, but all the same general principles still apply (e.g., diversification, risk tolerance, and time horizon).
The most common yardstick of an investment’s success is the rate of return. However, that is not the only measurement that matters! In fact, volatility is almost as important as rate of return for retirees who are taking systematic (e.g., monthly) withdrawals from a portfolio as explained in this article: Why Volatility Matters. Two other important measurements of an investment are liquidity and how well a given investment complements (diversifies) your other holdings.
Stocks – historically high returns and high volatility:
The stock market has had higher returns than almost all other asset classes. This is especially true when you consider time periods of 15 years or more. A frequently cited figure for stock market returns is 10% per year. However, the stock market can be volatile, and returns can often be much higher or lower than the average in any given year or even for a few years. It is typically not appropriate for retirees to have 100% of their portfolios in stocks. Most retirement investing strategies call for 40-80% of a portfolio’s investible assets to be allocated to stocks. Where on that spectrum (40-80%) depends on the individual’s risk tolerance, income needs, and financial goals.
Bonds – historically lower returns and lower volatility:
Bonds historically have had much lower returns than stocks, about 5-6%. Currently, interest rates on bonds are near historical lows. The current yield on a 10-year U.S. Government bond is only 3.1%. Therefore, a more reasonable return expectation for the next several years is 3-4% on investment grade bonds (the safest borrowers) and 4-7% on bonds issued by riskier borrowers (AKA as junk bonds or high yield bonds). See current bond yields HERE. The good news is bonds are a much more secure and predictable investment than stocks and add a lot of stability to a portfolio.
Mutual Funds and ETFs – an easy way to diversify:
Mutual funds, or exchange-traded funds (ETFs), make it easy to diversify over a basket of stocks, bonds, or a mixture of both in a single investment. The risk profile of mutual funds and ETFs range from very aggressive to very conservative. The returns will vary based on the risk profile of the fund and the performance of the overall market. Mutual funds and ETFs are much more practical for retail investors than picking individual stocks or bonds.
Real Estate – a nice diversifier with growth and income potential:
There are two ways to invest in real estate. You can buy shares in real estate investment trusts (REITs), which trade on the stock market, or you can buy physical real estate. Traded REITs typically focus on a certain type of real estate such as apartments, shopping centers, office buildings, or hotels. See the different REIT sectors and corresponding yields HERE. Residential rental properties can be a lot of work with unpredictable expenses. However, the average return has been almost 9% nationwide over the past 30 years when you consider cash flows and appreciation.
Retirement investing and reasonable expectations:
Most retirees want less risk and volatility than younger investors who have longer time horizons. This usually leads retirees to pursue a well-diversified moderate risk portfolio. That type of portfolio 50% stocks and 50% bonds has historically averaged just over 8% since 1926. However, there have been 10 year periods where a 50/50 portfolio has earned as little as 1% or as much as 17.6% (before fees or taxes). Many folks think that future returns will be a bit lower (based on a more mature / slow growing economy, and high current valuations) and therefore believe 5-7% gross returns for moderate portfolios is a more realistic expectation for the next couple decades. Luckily, the long-term inflation rate has only been around 3%, so even moderate returns can mean a boost in purchasing power or sustainable retirement income.
Note: This week’s article was written by guest author Andrew Rombach, a personal finance writer from LendEDU.com
*Past performance is not a guarantee of future returns.