Conservative assumptions about investment performance could save you stress after retirement

Anyone trying to plan for a financially secure retirement must consider at least seven key variables: current account balances, expected retirement income (Social Security, pension), expected spending, rate of inflation, income tax rates, life expectancy and investment rate of return.

For most people, there is adequate information available to make a good estimate about the first five variables. Life expectancy is less certain, but you should plan to live on the longer end of your family history.

That leaves the most difficult assumption in any financial plan — investment performance. Can you trust historical returns as a guide? Do you need a century of stock and bond performance to inform your future return assumption? Is it only relevant to count on returns from the modern global economy, say since 1990?

It’s easy to be led astray. Some basic financial literacy classes and online calculators show examples of compounding growth using 10 percent annual returns.

The people who go through the process of planning and being intellectually honest about their assumptions aren’t usually the people willing to speculate that investment markets will do all the heavy lifting for them by returning 10 percent per year. For people who think seriously about the sustainability of their life savings, return expectations should be lower, more like 4-8 percent, depending on where you reside on the spectrum of conservative to aggressive investors.

But how do you decide on a number? Financial plan projections are highly sensitive to this number.

Consider the example of Jack and Jill Savewell. They will retire in 2020 at 65 and expect to live to 92 and 95. They have $1 million saved – $700,000 in pre-tax retirement accounts, $100,000 in Roth IRAs that won’t be taxed and $200,000 in a brokerage account where capital gains taxes will apply. The Savewells will have $40,000 of combined Social Security income starting at age 67. They expect to spend $80,000 per year for all expenses.

Jack and Jill invest for moderate growth without taking too much risk. This means they hold a portfolio of 60 percent stocks (40 percent total U.S. market, 20 percent total non-U.S. market) and 40 percent bonds (30 percent U.S. and 10 percent foreign).

They utilize a financial plan program (or work with an advisor to do so) and enter the key assumptions and goals. When they come to the projected investment return field, they think about their own investment results, consult resources that forecast returns and simultaneously scratch their heads.

Over the past 30 years (1990-2019) investment returns realized by portfolios like theirs have achieved an average return of 8.3 percent per year. When they use this figure, the financial planning program tells them there is an 86 percent probability they can reach their life expectancy and cover all their expected spending.

The financial plan program runs 1,000 trials of various investment return patterns to help them better understand the range of potential outcomes. The 250th best trial suggests that they will have $4.5 million at the end of the plan. Investment returns were dramatically in their favor in this particular outcome. The 750th best outcome suggests they could have $678,000 at the end of the plan. It’s a massive difference in potential outcomes. Either way, there is a margin of safety that could preserve financial security if their expenses turn out to be higher than planned, they live longer or their investment performance is less than hoped.

But was their investment return assumption too optimistic?

Over the past 20 years, the same investment mix has realized an average annual return of just 6.4 percent (even after including the 20 percent return of 2019). If they use this as the assumed return, the overall probability of success for funding all expected spending remains relatively strong (82 percent).

But their margin of safety — the dollars left over at the end of the plan — is cut by more than half compared to the 8.3 percent average annual return assumption. This less robust projection could cause seemingly comfortable retirees to start to wonder, “What if”? What if we must withdraw money faster than expected? What if one of us needs long-term care that is not covered by Medicare? What if one of us lives to 100?

This doesn’t even consider realistic, but more difficult, scenarios. An optimistic estimate from Vanguard’s Capital Markets Model for this hypothetical investment portfolio is closer to 5.5 percent per year over the next 10 years. If these lower projected returns are realized, cutting spending would be necessary for this example to work.

This is why it is helpful to stress test your key assumptions about long-term financial security, to plan conservatively but welcome better-than-planned outcomes and to monitor your plans, correcting course as needed.