The Average Retirement Savings Return

Buried at the heart of every personal financial plan is a critical percentage: an average retirement savings return estimate.

And that leads to problem, frankly. That average retirement savings return is surely wrong for one or more reasons.

In this short blog post, therefore, let me identify the four most common errors we all (me included) easily make.

Average Retirement Savings Return Error #1: Nominal Return

A first quick error common to new investors: Using a nominal return—which is a return that hasn’t been adjusted for inflation.

What you and I want to do is use a real return—which is a return that has inflation subtracted out.

Example: One you start looking for investment return percentages to use in your own planning, you’ll stumble on the historical stock market return of 9% to 10%. But that’s a nominal return. Some of that 9% or 10% only represents inflation. (Probably about 3%?)

To adjust the 9% or 10% nominal return for the 3% inflation, you subtract the 3% from the 9% or 10%.

By the way, when you work with real return percentages in your calculations, the future savings and retirement income amounts you calculate use current-day dollar amounts—not inflated dollar amounts. That’s good…

Average Retirement Savings Return Error #2: Gross Return

Another easy error to make: Using the gross return rather than the net-of-expenses return.

But you and I need to adjust the return we expect for the expenses we pay to financial advisers and mutual fund companies.

If our retirement savings generate a gross 6% real return, for example, but we pay 1% to an investment adviser, we actually only earn 5%. So that 5% is the number we need to use in our calculations.

Note: If you’re paying more than half a percent (more than .5%) in investment fees, check out the popular Bogleheads.org forum for strategies and tactics about how to grind down your annual investment costs.

Average Retirement Savings Return Error #3: Single Percentages

And now an error that even many experienced do-it-yourself-ers make: We want to avoid using a single percentage value for your estimates.

In other words, you might be tempted to use a 6% average retirement savings return for your retirement calculations. That would seem to make sense since over the last 150 years or so, the stock market’s average, median annual return has run about 6%.

But here’s the problem. A 6% median annual return doesn’t mean you’ll earn 6%. It tells you there’s a 50% chance you’ll earn more than 6% and a 50% chance you’ll earn less. Almost surely, you’ll experience some percentage very different from that median.

The little table below gives more details using the example where someone annually saved $5,500 for retirement over 35 years and invested 75% of their savings in stocks and 25% in bonds sometime in the last roughly 150 years:

Make sure you understand the numbers in the preceding table—because too few people do.

The numbers show that the median outcome equals $620,358 an amount that reflects the median 5.99% return.

But in truth, wide variability occurs:

• The worst case 35-years-of-saving scenario (suffered by people who retired in 1920) occurred when savers averaged just over 1% annually for 35 years and accumulated about $231,000. And note that people who retired in 1921 or 1981 fared almost as poorly.
• One in five savers—see that line in the table that shows the 20th percentile—earned an average annual return of 4.38% or less and accumulated $437,000 or less. The most recent streak of people having a 20th percentile or worse outcome was 1977 through 1985.
• One in five savers—see that line in the table that shows the 80th percentile—earned an average annual return of 7.24% or more and accumulated $800,000 or more. Anyone who retired from 1997 through 2001 or in the last couple of years may have enjoyed this outcome.
• Finally, the best case 35-years-of-saving scenario (enjoyed by people who retired in 1999) occurred when savers averaged over 8% real returns for 35 years and ended up with more than $1,000,000.

To summarize: You and I don’t want to use a single percentage in our plans. We should use a range of percentages.

My suggestion? Of course, start with a median return for calculations. But you probably also want to estimate a likely “downside” outcome perhaps using as your average retirement savings return the median return minus 1% or 1.5%.

And then don’t ignore the equally likely upside. Perhaps you can estimate a likely “upside” using as your percentage the median return plus 1% or 1.5%.

Note: I blogged in more granular detail the steps for creating a retirement plan b here and for using cFIREsim to do the math here. But to encapsulate those discussions, you use cFIREsim to calculate a set of future values that show what would have happened in the past. Then use Microsoft Excel’s =RATE() function to calculate the annual rate of return that grows your savings to those future values.

Average Retirement Savings Return Error #4: Ignoring Allocation

A final error to avoid: You and I want to use a blended average retirement savings return that matches our asset allocation.

In other words, if you or I invest 75% into stocks and 25% into bonds, we should not just use the stock market’s average as our estimated return. We should instead combine the stock and bond return percentages to come up with a blended percentage.

As discussed in two other posts (Using FIRECalc for Retirement Plan B Calculations and Using Portfolio Visualizer for Retirement Plan B Calculations), the popular retirement planning calculations do let you work with blended retirement savings return estimates.

A Final Thought about Average Retirement Savings Return

We can all get smarter about the average retirement savings return estimates we use. And we should: Getting smarter should mean we do a way better job of preparing for our retirements.

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Retirement Plan B Tips: A Dozen Tips for a Better Retirement Plan “b”