Retirement planning hinges on one key assumption—the rate of return your investments will generate over time. Get this number wrong, and you risk either undersaving and running out of money or oversaving and sacrificing your current lifestyle unnecessarily. In this article, I break down how to determine a realistic assumed investment return, the factors that influence it, and the common pitfalls investors face.
Table of Contents
Why Assumed Investment Return Matters
The assumed rate of return is the foundation of retirement calculations. It dictates how much you need to save, how long your money will last, and whether adjustments are necessary along the way. A small difference in this assumption can lead to vastly different outcomes.
For example, suppose I project a 7\% annual return on my portfolio. If I save \$500 a month for 30 years, my ending balance would be:
FV = 500 \times \frac{(1 + 0.07)^{360} - 1}{0.07/12} \approx \$567,000But if I adjust the return assumption to 5\%, the final amount drops to:
FV = 500 \times \frac{(1 + 0.05)^{360} - 1}{0.05/12} \approx \$402,000That’s a \$165,000 difference—just from a 2\% change in assumptions.
Historical vs. Forward-Looking Returns
Many investors rely on historical averages to set their return assumptions. The S&P 500 has delivered about 10\% annualized returns over the past century. But this doesn’t account for inflation, fees, or future economic conditions.
A more prudent approach is to use forward-looking estimates. Research from experts like Aswath Damodaran suggests that expected equity returns should factor in current valuations, dividend yields, and earnings growth. For instance, the Gordon Growth Model estimates returns as:
r = \frac{D_1}{P_0} + gWhere:
- r = Expected return
- D_1 = Next year’s expected dividend
- P_0 = Current stock price
- g = Long-term growth rate
If the S&P 500 has a dividend yield of 1.5\% and expected earnings growth of 4\%, the model suggests a 5.5\% nominal return—far below historical averages.
Table: Historical vs. Forward-Looking Return Estimates
| Asset Class | Historical Return (Nominal) | Forward-Looking Estimate (Nominal) |
|---|---|---|
| U.S. Large-Cap | 10% | 5.5% – 7% |
| U.S. Bonds | 5% | 3% – 4% |
| International Stocks | 8% | 6% – 7.5% |
The Impact of Fees and Taxes
Many investors forget to subtract fees and taxes from their return assumptions. A 7\% gross return becomes 5.5\% after a 1\% fee and 20\% capital gains tax. The formula adjusts to:
r_{net} = r_{gross} \times (1 - tax) - feesIf my gross return is 7\%, with a 1\% fee and 20\% tax on gains:
r_{net} = 0.07 \times 0.80 - 0.01 = 0.046 = 4.6\%This significantly alters retirement projections.
Sequence of Returns Risk
Even if the long-term average return holds, the order in which returns occur—known as sequence risk—can devastate a retirement plan. Poor returns early in retirement force larger withdrawals from a shrinking portfolio, increasing the chance of depletion.
For example, consider two retirees with a \$1,000,000 portfolio withdrawing \$40,000 annually.
- Retiree A faces negative returns early:
- Year 1: -10\%, balance = (\$1,000,000 - \$40,000) \times 0.90 = \$864,000
- Year 2: -5\%, balance = (\$864,000 - \$40,000) \times 0.95 = \$782,800
- Retiree B has strong early returns:
- Year 1: +10\%, balance = (\$1,000,000 - \$40,000) \times 1.10 = \$1,056,000
- Year 2: +5\%, balance = (\$1,056,000 - \$40,000) \times 1.05 = \$1,066,800
Despite the same average return, Retiree A’s portfolio suffers more.
Conservative vs. Optimistic Assumptions
Some financial planners advocate using a conservative return estimate (e.g., 4-5\%) to build a safety margin. Others argue that too conservative an approach leads to excessive savings and reduced quality of life during working years.
I recommend stress-testing multiple scenarios. For instance:
- Base Case: 6\% return
- Pessimistic Case: 4\% return
- Optimistic Case: 8\% return
If my retirement plan works even in the pessimistic case, I can proceed with confidence.
Adjusting for Inflation
Nominal returns don’t account for inflation. A 7\% nominal return with 3\% inflation yields only a 4\% real return:
r_{real} = \frac{1 + r_{nominal}}{1 + inflation} - 1Plugging in the numbers:
r_{real} = \frac{1.07}{1.03} - 1 \approx 3.88\%Retirement projections should use real returns to maintain purchasing power.
Final Thoughts
Choosing an assumed investment return isn’t about picking the highest possible number—it’s about balancing realism with prudence. Historical data provides a starting point, but forward-looking estimates, fees, taxes, and sequence risk must also factor in. Stress-testing different scenarios ensures resilience, and using real returns keeps projections grounded.
