What rate of return does your portfolio have to earn to achieve your target income (withdrawal) and savings/bequest goals? Sadly, too many retired investors cannot answer this question. So let's deal with it straight away. Given your goals, as well as your expected remaining years of life, you can derive the minimum compound annual real rate of return your portfolio must earn to meet them. The table on this page shows one example of this calculation.
Here is how to use the table. In the upper left cell is "Exp =" refers to your estimate of your remaining years of expected life, in this case 15 years. (The Model Portfolio Solutions in our Members' Section cover expected lifetimes of 10 to 50 years.) The top line contains a series of numbers, ranging from 3% to 10%. These represent your target annual income (withdrawal), expressed as a percentage of the starting value of your portfolio. . All our models use real (after inflation) inputs and rates of return. Hence, if you estimate your income target in today's currency, and then divide it by your capital today, you get your real target income (withdrawal) rate.
Along the left side of the table is a series of numbers ranging from 0% to 200%. These represent your target bequest/savings goal, also expressed in real terms as a percentage of the starting value of your portfolio. The cell at the intersection of each target income and target bequest goal shows the minimum compound annual real return that your portfolio must earn. If, over your expected remaining life, your portfolio earns this compound annual rate of return, it should end with a value of zero after your bequests are paid out. For example, suppose the target income you want your portfolio to produce equals 5% of its initial value. You also would like to leave bequests equal to 100% of your portfolio's current value after you die. The table shows that achieving these goals requires that you earn a compound annual real rate of return of at least 5.50% on your portfolio over this period. (Note that this rate of return is also sometimes called a "geometric average" or the "internal rate of return.")
There are four points to keep in mind about the returns in this table. First, as we noted, they are real returns, and do not include inflation. We use real returns because this focuses attention on maintaining the purchasing power of your income and savings over time. When you focus on nominal returns, high inflation can cause you to think you are doing quite well, even as the purchasing power of your assets shrinks and your real standard of living declines.
This also raises a second important point: in our analyses, we calculate real returns by removing the effect of inflation from nominal asset class returns. To do this, we use a broad consumer price index. However, it may be the case that the actual cost of living faced by a retired person does not exactly correspond to changes in the broad consumer price index. Unfortunately, until governments start to produce "retired consumers" price indexes, there is no easy way for us to take this difference in actual inflation into account in our models. At this time, all we can suggest is a "second best solution." For example, someone expecting post-retirement cost of living changes above the reported consumer price index could use a target income (withdrawal)/starting capital ratio that is somewhat higher than what they estimate they need today.
Third, these returns are after-tax. To convert these returns to a pre-tax basis, divide them by an amount equal to 1 less your marginal tax rate. (However, if your investments are held in a tax advantaged retirement account, the returns we show are the pre-tax returns).
Fourth, in order to achieve a 5.50% compound annual return, your average annual return will have to be significantly higher than this amount, because you will be investing in risky assets. When the standard deviation of annual returns (a proxy for risk) on an asset or portfolio is greater than zero, its compound average annual rate of return will be lower than its simple (arithmetic) average rate of return over time. This is due to a phenomenon called either "variance drain" or "volatility drag." This is an important concept that too few investors clearly understand.
Here's example that should help make it clear. Consider an investment that over five years earns annual returns of 10%, 5%, (20%), (5%), and 25%. Over this five year period, the arithmetic average return on this investment was 3.00%. The standard deviation of these returns was 16.81%. Because of this variability, the compound average annual return over this five year period was only 1.87%.
A quick (if not perfectly accurate) estimate of the size of a portfolio's volatility drag is one half the square of its standard deviation.
One last point: The shaded cells in the table show real compound annual rates of return that, based on our view of historical experience, seem imprudent to expect in the future. The lower the required compound annual real rate of return, the higher the probability that wise asset allocation and investment selection will result in its achievement.
| Exp=15 | 3% | 4% | 5% | 6% | 7% | 8% | 9% | 10% |
| 0% | -8.36% | -5.73% | -2.82% | -0.54% | 1.56% | 3.52% | 5.39% | 7.19% |
| 50% | -0.18% | 1.24% | 2.65% | 4.05% | 5.46% | 6.86% | 8.26% | 9.68% |
| 100% | 3.26% | 4.37% | 5.50% | 6.64% | 7.81% | 8.99% | 10.20% | 11.42% |
| 150% | 5.53% | 6.49% | 7.48% | 8.49% | 9.53% | 10.59% | 11.68% | 12.79% |
| 200% | 7.24% | 8.12% | 9.02% | 9.95% | 10.90% | 11.88% | 12.88% | 13.92% |
Once you have quantified the goals for your portfolio you need to implement a plan to achieve those objectives. The allocation of your assets is critical. Let's proceed to What Asset Allocation is Right for You?