What Returns Does Your Portfolio Need to Earn to Achieve Your Retired Investing Goals?

The answer to this question is derived from the answers to the previous questions.

The first question is how much annual income will you need to have the lifestyle you want after you retire? To make things easier, this entire discussion will be in so-called "real" terms, assuming the effects of inflation have been removed. For example, a number of studies suggest that people generally desire replace 70% to 90% of their pre-retirement income. If we assume that amounts to $100,000 today, a target post-retirement income might be $80,000.

The second step is to subtract from this the annual income an investor expects to receive from non-portfolio sources, including a state pension (e.g., Social Security in the United States), a company pension (if you are in a defined benefit plan) and part-time work. Let's say these sources amount to $30,000. That leaves $50,000 in annual cash flow (i.e., $80,000 less $30,000) that our investor's portfolio of financial assets must provide after he or she retires.

The third step is to determine the size of the bequest, if any, that our investor wants to leave after he or she dies (and note that for many people, this target bequest also serves as precautionary savings for unanticipated health care costs not covered by insurance). One way to think of this is in terms of a multiple of your annual portfolio income. Let's say, for example, that our investor wants to leave a bequest equal to ten times his or her annual portfolio income, or $500,000.

The fourth step is to estimate the number of years the investor expects to live in retirement. As we have noted, a "mortality table" provides the expected years of remaining life for people at different ages. However, these estimates are simply the midpoints of distributions that can be quite wide; some people will die sooner than the mortality table's estimate, while some people will die later.

Interestingly enough, researchers have found that individual's own estimates of their remaining years of life are often more accurate than a simple random guess (probably because they are based on a knowledge of family and personal health histories).

The fifth step is to estimate the minimum real (after inflation) compound rate of return you will need to earn on your portfolio to achieve your income and bequest goals, given assumptions.

Technically, this is the rate at which equates the present value of your future income withdrawals and final bequest to the current value of your portfolio.

For example, assume you have saved $1,000,000, expect to live for 20 years after retirement, desire $50,000 in annual cash flow from your portfolio, and want to leave a $500,000 bequest. The minimum compound real rate of return that you will need to earn on your portfolio is 3.61%. This would leave your portfolio value equal to zero after paying out the $500,000 bequest at the end of year 20.

That looks easy, right? Wrong. Remember that the annual real rate of return on your portfolio will vary, unless it is completely invested in a so-called "ladder" of real return bonds with maturities equal to $50,000 per year. Because portfolio returns vary, your annual real return is very unlikely to equal 3.61%.

Also, because you are withdrawing $50,000 each year from your portfolio, annual real returns below 3.61% can significantly reduce the probability that you will achieve your retired investing goals.

When you are a retired investor, portfolio losses are much more damaging that when you are saving for retirement.

For this reason, the target compound annual real return you need to earn on your portfolio to achieve a given target probability of achieving your retired investing goals will generally be greater than the minimum required to achieve your goals. How much greater? As a general rule, the spread between the minimum return you require and the target you set for your portfolio will increase with the minimum required return.

As we will discuss in greater detail in the next section this is because to achieve the higher minimum you must invest in riskier assets that have greater standard deviations of annual return (i.e., volatility), and thus greater risk of a very damaging negative portfolio return in any given year.

Also note that that this analysis does not explicitly take into account residential property owned by an investor.

This is because different investors will treat this in different ways. For example, one investor may enter into a "reverse mortgage" to generate post-retirement income that does not depend on the returns on her investment portfolio. Another may sell his large house, purchase a smaller one, and add the profits realized (technically the "equity extraction") to his financial investment portfolio. And still another may consider her house as her bequest, and thereby reduce the size of the bequest she expects her financial investment portfolio to fund.

Next: Taking a closer look at the minimum compound annual real return needed to achieve different cash flow and bequest goals.