Why Rate of Return Matters with Retirement Planning
Updated: Sep 6, 2021
NOTE – see the end of the article for a link to the video version of this post
Look, there are plenty of pleasant ways to spend your time when it comes to thinking and planning your retirement. You can visualize yourself on a beach sipping daiquiris and listening to the surf, or you can feel the warm cup of coffee in your hands as you curl up in your robe and open the morning paper with no feeling of urgency for the day.
All of this is well and good. Assuming, that is, that you will be able to retire.
Now for the rude awakening—most of us are not on track to retire, at least not any time soon. Here’s the norm—we withhold 6% of our paycheck into our company’s 401K which has a 3% matching and we assume, after 25 or 30 years, that we will be good to go. Early on we select a moderate or moderate aggressive portfolio and that portfolio, on average, returns around 7% annually.
We feel pretty good about this because our money is making money which is making money—we are, after all, embracing compound interest.
But, and get this—it’s not enough. Not by a long shot.
Look, if we want to retire and live off of $25,000 a year, that’s certainly a choice we have. If we want to skimp and live on beans and rice, then we can go ahead and forgo any kind of retirement planning. But, if you’re like me, that doesn’t sound too appealing.
It’s time to look at serious numbers in a serious way to get a handle on where we need to be for our planning purposes, whether you are 25, 40, or 55 years old.
Here’s the fact of the matter—you have to get rates of return above 10% in your retirement account if you ever hope to reach the point of being able to retire. It is simply a must. I’m going to run two scenarios with you to prove that earning 7% will not get you where you need to go. To get to that point, you have to get serious about saving AND get your money invested in a way that earns more than 10% a year on average.
To do this planning, I’m going to be using a sample individual that we will call Sam. Sam is 40 years old and his family currently lives off $75,000 in living expenses. They enjoy a comfortable life, have a nice house, two kids, a dog, and several cars. It’s true that when they retire, Sam and his wife will own their home, will probably downsize, and will not have kids living at home, but, let’s face it, they’ll want to travel, visit grandkids, and be able to live comfortably.
Therefore, for our two calculations, we are going to assume that they will need $75,000, in today’s dollars, to survive. We are also going to assume that they will retire at age 65 and live until 95, which means that their retirement will need to fund 30 years of living expenses.
Now, we are also going to assume that Sam spent the first 18 years of his career completely ignoring retirement and savings altogether. He has nothing in the bank for retirement and is starting at 0. Because he is 40 years old, he will be retiring in 25 years.
What we need to know, is how much money will Sam need at age 65 in order to comfortably retire on $75,000 a year for the next 30 years.
This requires some serious number crunching and to run these calculations, I used a HP 12c Platinum financial calculator which offers the following financial calculations:
N=number of years
PV – present value
PMT – payment
FV – future value
I found a great tool on the internet that also works: https://www.lehigh.edu/~sgb2/hp12c.html
Now, the last thing we need to consider before embarking on this most important journey of number crunching is the rate of inflation.
Ah, yes, inflation, the thing we investors love to ignore and but have to face on a regular basis. The short version is that our dollars today will be worth less tomorrow. Each year inflation creeps in around 3% on average, which essentially means th
at something that costs $100 this year will cost $103 next year. Seems small and petty, but in the large scheme of things, can be absolutely huge.
Here’s what I mean by that—Sam wants to live on $75,000 in TODAY’s money. But, he’s going to retire in 25 years, and in 25 years, that $75,000 is actually going to be $157,033.
Did you get that? In 25 years, Sam will need over $150,000 just to live like he does today. Dang, inflation is an unforgiving beast. But, if you think that’s bad, consider what Sam will need at age 95 to live his current $75,000 lifestyle—nothing less than $381,161
I’m going just let that sink in for a moment.
Yes, you read that right.
It’s clearly time to get serious about retirement. Those of you currently living a $100,000 lifestyle will need $508,214 a year just to maintain that quality 55 years from now.
So how in the world are we going to figure out how much money we need to retire? That’s where a handy financial calculator can help us tremendously.
In our first scenario, Sam is going to be earning the standard 7% on his account. As a disclaimer, this projection will be incredibly depressing and if this doesn’t convince you to invest your money in a different way, nothing will.
As I said earlier, the interest rate is right around 3% on average each year, so it would make sense to just subtract 3% from 7%, but to get the true, “Real rate” you have to divide the nominal or expected rate by the rate of interest, so you actually end up with 3.9%. In other words, if Sam is getting 7% return, he is really only getting 3.9%. Depressed yet? Just wait.
Here’s our calculation—Sam is retiring at 65 and will live for 30 years and needs $75,000 a year at 3.9% return, so, according to our calculator, he needs $1,312,795.
Well that doesn’t sound too bad, right?
Wait—we have to go back and retroactively add in inflation—that $1,312,795 is in today's dollars, but at age 65, it will actually be (in dollars 25 years from now) $2,748,701.
He needs close to 3 million dollars to live today’s lifestyle in retirement.
Okay, so how to get to that point? He has 25 years and no savings. Let’s run the numbers—starting at 0, with 25 years, getting a 7% return, Sam needs to save… per year…are you ready?
$43,458 dollars. Per year
That’s over $3,500 a month. That’s insane. Poor Sam is going to be working until age 80.
Now, some of you will be saying, WAIT – what if Sam already has $50,000 in a retirement account? If we throw that into the calculation, then it takes $271,371 off of his required amount. It ends up dropping his monthly payment by $250 a month. He still loses.
Okay, okay, let’s start to get more positive here. Let’s say Sam happens upon a strategy for investment that yields a higher return. He invests his money in a way that generates 10% or more each year. He increases his financial acumen and takes his money into his own hands and gets significant returns.
And this is not hard to do.
Let’s run our scenario again, but with Sam earning 12% as his rate of return. After we calculate inflation, that 12% becomes 8.7%.
To live his current $75,000 lifestyle at age 65, Sam now needs $1,657,210—a full 60% LESS than he needed earning 7%.
To get to that amount starting at 0 but with 25 years of saving at 12% per year, Sam now only needs to put in $12,429 a year or $1,035 a month. THAT’S OVER $2,000 LESS PER MONTH that he has to put in because his rate of return is 5 percentage points higher. That’s the power of compound interest.
Okay, so, you say, what if Sam has $50,000 already saved up? Plugging that number in knocks his necessary amount in HALF and makes his monthly savings amount a staggeringly low $504 a month. Compare that to $3,250 from above and you can see that he can realistically plan for a life of ease and retirement. Heck, if he and his wife up their savings, they can even retire early.
Here’s the takeaway—actual retirement takes money—and a lot of it once we account for inflation. But to get to that point, we have to ditch the mediocre returns and start investing with purpose. Take your money in your own hands and get the returns you deserve so you can enjoy the future that your wealth can build.
Check out the video version of this post as well: