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Dear MarketWatch,
I’m a 31-year-old engineer. At some point, I want to quit my current job and switch to a less profitable but more enjoyable career. But before I do that, I want to use the higher pay to set myself up so I won’t have to worry about retirement or work past age 60. As a nerd, I’ve built far too many retirement models and I keep running into the same question: what rate of return do I use? I like to bake a 2.65% general inflation into my calculations as some things grow (groceries, property taxes) and some things don’t (mortgage). I use 4% inflation for health care costs.
If I’m including inflation, should I be using the recommended 6%-7% estimated market return on investments? I see that everywhere, but it appears that these numbers come from the typical market return (9-10%) minus the general estimated inflation (3%). I usually use 8.65% (2.65% plus 6%) to be conservative. Am I right, being too conservative, or being too optimistic?
Thank you for your help,
L.D.
Dear L.D.,
This is such a good question, and I’ll tell you why — you’re thinking very carefully about the assumptions you need to have a sustainable retirement fund, which goes far beyond just the amount of money you put away every month. Incorporating as much detail as you can into your calculations will really pay off in the end.
As you’ve pointed out, there is no set figure for a rate of return — it depends on your comfort, what type of investments you’re using and a whole list of other factors. Anything you decide can be considered too conservative or too bullish for the person next to you. Still, the wrong assumption for a rate of return can make or break your retirement plans.
That being said, there are ways to approach this. First, determine the “risk-free rate,” which often is determined by the 10-year U.S. Treasury rate, said Rick Vazza, president of Driven Wealth Management. “An expected return all depends on where they are comfortable falling on this risk/return spectrum,” he said. For speculative investments, you want a higher rate of return because you’re essentially gambling in a riskier arena. If you’re investing in something like the S&P 500 index SPX, +0.24%, you may be OK with a lower rate because historically the companies that make up that index perform well.
“I think all too often we incorrectly assume an investor’s expected return should just be the S&P 500, when in fact they likely have a totally different risk/return profile than the index,” he said.
As I’m sure you’ve seen, all the big investment firms tackle this question differently and many analysts have their own forecasts. “My recommendation to the DIY planner is to start with historical averages,” said Ron Guay, a financial planner at Garrett Investment Advisors. “If this paints a picture of a comfortable retirement, spend the rest of your time modeling conservative or stressed scenarios and deciding how you would respond.”
This could mean making extra calculations and spreadsheets for situations where you delay your retirement, reduce your spending or find yourself in a financial dilemma. You may find this task enjoyable, especially if you like running scenarios and using spreadsheets, or you may want to reach out to a financial planner who can help you with any uncertainties.
There are so many other variables to consider. For example, your estimate for a rate of return — or your comfort level associated with that figure — may change when you switch careers or finally retire, because you’ll be bringing in less money and eventually start to withdraw from those funds. I’m not sure what kind of retirement calculators you use, but you may want to try a Monte Carlo simulation, which is far more powerful a method than a straight-line projection, according to MarketWatch contributor Dan Moisand.
You asked “what rate of return do I use?” but why not flip the question to “what return do I need to ensure I can do everything I want?,” said Artie Green, principal and wealth adviser at Cognizant Wealth Advisors. You’d have to come up with a retirement plan, or in your case some sort of a plan that incorporates your job switch too. “Once you know what that return needs to be, you can come up with an investment strategy that minimizes the risk associated with the needed return,” he said. “No one can control investment returns but we can control investment risk.”
Be sure to think big picture, though. You mentioned an assumption for health expenses, but keep in mind that as you age, the number of health care bills — and the cost associated — typically rise, too. No one can predict the future, but you have to take into account you may live longer than you expect to, in which case you’ll need more money to live on. Marguerita Cheng, chief executive officer of Blue Ocean Global Wealth, assumes a health care inflation of 7%, she said. “I would advise the reader to be mindful of health care and long-term care expenses, which inflate at rates higher than general inflation,” she said.
My last point is this: keep your spreadsheets flexible. You’re 31, a lot of things can change in the next decade. Marriage, kids, college savings, purchasing a home or another expensive asset, a health emergency, divorce — anything can happen, said Daniel Lash, a partner at VLP Financial Advisors. “Plans are great to help achieve goals but they should be updated as changes in your life occur.”
Have a question about your own retirement savings or where to live in retirement? Email us at HelpMeRetire@marketwatch.com
