Retirement planning question...guesstimating rates of return

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alohabear
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Retirement planning question...guesstimating rates of return

Postby alohabear » Wed Aug 08, 2012 12:12 pm

When trying to determine whether you're saving enough for retirement, what rate of return do you use for predicting the size of your retirement account(s) when you hit retirement age? My agency has a website that calculates estimated monthly payout for our retirement funds, based on an assumed 4% annual growth. That seems pretty conservative to me (especially when nuts like DR claim a 12% return), but I was wondering if that seems reasonable to others. Personally, I prefer the guesstimate to be relatively conservative because I'd rather over-save for retirement than under-save. Thoughts?

(Edited to correct typos.)
Last edited by alohabear on Wed Aug 08, 2012 2:43 pm, edited 1 time in total.

DoingHomework
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Re: Retirement planning question...guesstimating rates of re

Postby DoingHomework » Wed Aug 08, 2012 12:29 pm

You would be best to do your calculation in terms of real return rather than nominal return. Real return is the return you get after accounting for inflation.

No one know for certain what markets will return in the future so the only possible guide is the past. In the past, stocks have returned about 6.6% real and bonds have returned 2-3%. When inflation was running at 5% per year that meant the nominal returns were 7-8% for bonds and about 11.6% for stocks.

Many believe that those returns will be much lower in the future. In spite of all the nuts claiming otherwise, inflation in the US is running at about 1.5% and will likely stay at that level for at least the next few years. But if you are worried about what happens over the next 20-30 years before you retire, I suspect inflation will be back at the historic rate of about 4-5% and returns will be about 6-7% for bonds and about 10% for stocks. I personally am assuming 3% return for bonds and 7% for stocks (nominal).

You then have to compute a composite return for yourself. If you plan to have 70% of your money in stocks and 30% in bonds then your composite return will be (0.7)(0.07)+(0.3)(0.03)= 5.8% (using my assumed returns)
Last edited by DoingHomework on Wed Aug 08, 2012 12:38 pm, edited 2 times in total.

Tightwad
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Re: Retirement planning question...guesstimating rates of re

Postby Tightwad » Wed Aug 08, 2012 12:31 pm

When you say "retirement funds" is it safe to assume you mean equities? Those funds mean something different to everybody.

Personally, they mean equities to me & I always estimate a range of 6%-8% in annual return. Anything over that is gravy.

alohabear
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Re: Retirement planning question...guesstimating rates of re

Postby alohabear » Wed Aug 08, 2012 1:06 pm

Tightwad wrote:When you say "retirement funds" is it safe to assume you mean equities?


I was specifically referring to my TSP.

DoingHomework wrote:You then have to compute a composite return for yourself. If you plan to have 70% of your money in stocks and 30% in bonds then your composite return will be (0.7)(0.07)+(0.3)(0.03)= 5.8% (using my assumed returns)


Right now my allocation is approximately 32% bonds and 68% stocks, so using your assumed returns that would be about 5.7%, making the 4% used on my benefits website relatively conservative.

Thanks to both of you for your input.

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Re: Retirement planning question...guesstimating rates of re

Postby tdelamater » Wed Aug 08, 2012 4:35 pm

read this: http://www.mrmoneymustache.com/2012/05/29/how-much-do-i-need-for-retirement/

I think a 4% withdrawal rate is fairly reasonable. I would not make any predictions on the future returns (if any), and focus more on how much you would need to withdraw to maintain a reasonable standard of living during retirement. If you have to withdraw too much, no investment return is going to compensate for that.

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Re: Retirement planning question...guesstimating rates of re

Postby DoingHomework » Wed Aug 08, 2012 4:46 pm

tdelamater wrote:read this: http://www.mrmoneymustache.com/2012/05/29/how-much-do-i-need-for-retirement/

I think a 4% withdrawal rate is fairly reasonable. I would not make any predictions on the future returns (if any), and focus more on how much you would need to withdraw to maintain a reasonable standard of living during retirement. If you have to withdraw too much, no investment return is going to compensate for that.


4% withdrawal rate is awfully high these days. 3.5% is probably more reasonable with 3% being more conservative.

It's fine to assume no return over the next 30 years but that will likely lead to a very pessimistic plan.

stannius
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Re: Retirement planning question...guesstimating rates of re

Postby stannius » Wed Aug 08, 2012 5:23 pm

tdelamater wrote:I think a 4% withdrawal rate is fairly reasonable. I would not make any predictions on the future returns (if any), and focus more on how much you would need to withdraw to maintain a reasonable standard of living during retirement. If you have to withdraw too much, no investment return is going to compensate for that.


The 4% rate implicitly includes an assumption of future returns. Or rather, it assumes a probability distribution of returns. Or rather, it assumes that future returns follow the same patterns as past returns.

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Re: Retirement planning question...guesstimating rates of re

Postby Bichon Frise » Wed Aug 08, 2012 9:55 pm

tdelamater wrote:read this: http://www.mrmoneymustache.com/2012/05/29/how-much-do-i-need-for-retirement/

I think a 4% withdrawal rate is fairly reasonable. I would not make any predictions on the future returns (if any), and focus more on how much you would need to withdraw to maintain a reasonable standard of living during retirement. If you have to withdraw too much, no investment return is going to compensate for that.


I plan to retire for 60 years. Is 4% appropriate?

Stochastic modeling is another way to forecast. As with all predictions, it is only as good as the assumption. And time will tell if the assumption is good or not. An ouiji board does excellent as well.
Bichon Frise

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tdelamater
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Re: Retirement planning question...guesstimating rates of re

Postby tdelamater » Wed Aug 08, 2012 10:34 pm

stannius wrote:
tdelamater wrote:I think a 4% withdrawal rate is fairly reasonable. I would not make any predictions on the future returns (if any), and focus more on how much you would need to withdraw to maintain a reasonable standard of living during retirement. If you have to withdraw too much, no investment return is going to compensate for that.


The 4% rate implicitly includes an assumption of future returns. Or rather, it assumes a probability distribution of returns. Or rather, it assumes that future returns follow the same patterns as past returns.


Sorry if I wasn't clear. Yes, there is an implied future return. What I meant was that it's better to focus on what you can control (your withdrawal rate) as opposed to something you can't really control (your future returns).

Now that I re-read the original question, it's obvious alohabear is not asking "can I retire" but instead asking "I'm trying to determine if I'm saving enough for retirement, but I need to know what rate of return I might reasonably expect."

My answer to that would probably use the dividend-based approach to estimating total stock returns: http://www.investopedia.com/articles/04/020404.asp#axzz231c2g5eF which does actually happen to be about 4%.

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Re: Retirement planning question...guesstimating rates of re

Postby Northern light » Thu Aug 09, 2012 6:13 am

Even though a 4% withdrawal rate (1/25) might seem fair the year you retire (say, 65 years old), it seems extremely conservative when you are 79?

I admit I will have a low but safe life long pension at the bottom (will not end up on the street), but I would probably calculate that I will be in the saddle unitl 85 or so, and if I retire at 65 I thereby can spend 1/20 of my cash every year. That is; 1/20 the first year, 1/19 the second, 1/18 the third and so on. The tenth year (age 75) I would spend 1/10, or 10% of the cash I have left.

I raise my kids to be happy, well educated people that can chose their path in life. Shure they will need and get financial help during college, buying their first home and start a family - but that is in their 20:s and 30:s - 25-30 years before I statisically toss in the towel. At that point they are in their late 50:s and will statistically be in the best financial position of their life. Whats the point for me to save money just to leave them with it when they need it the least?

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Re: Retirement planning question...guesstimating rates of re

Postby stannius » Thu Aug 09, 2012 8:32 am

Northern light wrote:Even though a 4% withdrawal rate (1/25) might seem fair the year you retire (say, 65 years old), it seems extremely conservative when you are 79?

I admit I will have a low but safe life long pension at the bottom (will not end up on the street), but I would probably calculate that I will be in the saddle unitl 85 or so, and if I retire at 65 I thereby can spend 1/20 of my cash every year. That is; 1/20 the first year, 1/19 the second, 1/18 the third and so on. The tenth year (age 75) I would spend 1/10, or 10% of the cash I have left.


The 4% is calculated at the beginning of the withdrawal period and then only adjusted for inflation every year. It's a percentage of the starting portfolio amount, so as the portfolio is drawn down, and the withdrawal goes up with inflation, it does become a larger and larger fraction of the portfolio in each year. (depending on actual investment returns, of course). It's also only designed to last 30 years, not indefinitely.

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Re: Retirement planning question...guesstimating rates of re

Postby DoingHomework » Thu Aug 09, 2012 10:17 am

stannius wrote:The 4% is calculated at the beginning of the withdrawal period and then only adjusted for inflation every year. It's a percentage of the starting portfolio amount, so as the portfolio is drawn down, and the withdrawal goes up with inflation, it does become a larger and larger fraction of the portfolio in each year. (depending on actual investment returns, of course). It's also only designed to last 30 years, not indefinitely.


There are lots of different ways that a withdrawal rate is applied.

A 4% withdrawal rate, applied the way you describe (i. e. as a percentage of the initial balance) will last exactly 25 years with certainty if the investment is held in cash. To last 30 years with certainty the invested funds must earn 1.096% annually. That is achievable with 30 year Treasuries right now earning 2.75%. The only uncertainty involved in any of that is the impact of inflation. And even that is well-cushioned by the spread of the Treasury rate over the required return rate (2.75%-1.096%=1.65% is very close to the current inflation rate of 1.66%)

So basically, if someone retires at 65 and withdraws 4% of the initial balance every year and invests the money in 30 year US Treasuries held to maturity, the money will last 30 years (until age 95) with certainty but the purchasing power of those withdrawals is subject to risk if the inflation rate exceeds the excess earning of the Treasuries over the required rate of 1.096%.

What NL described is not much different from the actuarially required withdrawal rate for IRA MRDs. You basically take 1 over your life expectancy each year - it's not quite like that but pretty close. So in effect, every American is required to follow his plan after age 70.5 (or withdraw more.)

The trouble comes in when people retire early. In that situation a 3% or 3.5% rate is safer.

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Re: Retirement planning question...guesstimating rates of re

Postby tdelamater » Thu Aug 09, 2012 11:42 am

DoingHomework wrote:
stannius wrote:The 4% is calculated at the beginning of the withdrawal period and then only adjusted for inflation every year. It's a percentage of the starting portfolio amount, so as the portfolio is drawn down, and the withdrawal goes up with inflation, it does become a larger and larger fraction of the portfolio in each year. (depending on actual investment returns, of course). It's also only designed to last 30 years, not indefinitely.


There are lots of different ways that a withdrawal rate is applied.

A 4% withdrawal rate, applied the way you describe (i. e. as a percentage of the initial balance) will last exactly 25 years with certainty if the investment is held in cash. To last 30 years with certainty the invested funds must earn 1.096% annually. That is achievable with 30 year Treasuries right now earning 2.75%. The only uncertainty involved in any of that is the impact of inflation. And even that is well-cushioned by the spread of the Treasury rate over the required return rate (2.75%-1.096%=1.65% is very close to the current inflation rate of 1.66%)

So basically, if someone retires at 65 and withdraws 4% of the initial balance every year and invests the money in 30 year US Treasuries held to maturity, the money will last 30 years (until age 95) with certainty but the purchasing power of those withdrawals is subject to risk if the inflation rate exceeds the excess earning of the Treasuries over the required rate of 1.096%.

What NL described is not much different from the actuarially required withdrawal rate for IRA MRDs. You basically take 1 over your life expectancy each year - it's not quite like that but pretty close. So in effect, every American is required to follow his plan after age 70.5 (or withdraw more.)

The trouble comes in when people retire early. In that situation a 3% or 3.5% rate is safer.


I agree on all points with Doing Homework. Very wise.

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Re: Retirement planning question...guesstimating rates of re

Postby alohabear » Thu Aug 09, 2012 4:58 pm

tdelamater wrote:Now that I re-read the original question, it's obvious alohabear is not asking "can I retire" but instead asking "I'm trying to determine if I'm saving enough for retirement, but I need to know what rate of return I might reasonably expect."


Exactly. I know rate of withdrawal is going to be important when I retire, and figuring out the rate at which I want to withdraw will help me determine my goal for the overall target amount I need to save. My concern, since I have 30 more years 'til retirement, is whether I'm saving enough to get to that overall goal.

Based on the link you provided and the other responses, figuring a 4% return is probably as good a conservative guess as any.


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