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April 23, 2018

Guidelines for Projecting Retirement Savings


One of the challenges of retirement planning is projecting how much money you will have in the future. For those of us who are many years away from retirement, this a big uncertainty. We can use various tools and calculators, but they often rely on us making assumptions.

The assumptions largely focus on three things: age, savings and rate of return. Age is how old you will be at your planned retirement date. This is the easiest of all the assumptions. For most people, retirement will be between 65 and 70. (The greater your ability to work to 70, the more money you will have accumulated for retirement.) Obviously, the actual date will depend on both your health and what happens to your career between now and the planned retirement date.

The next two factors are tougher to forecast. Savings is what we intend to set aside between now and our retirement date. The rate of return is what we expect to earn on our portfolio between now and then. Both are levers we can pull either through the percentage of income we set aside or the allocation we choose.

This brings us back to the commentary I wrote last week about expected values. Expected values are a form of scenario analysis. While it is certainly easier to calculate expected values when there are fixed and known odds—as is the case with Mega Million and Powerball lottery tickets—a form of scenario analysis can be done with retirement planning even if you lack complex software and/or have no idea what Monte Carlo simulation is. (A Monte Carlo simulation estimates values based on many possible scenarios.)

Let’s start with savings. You know how much you can save now. You can likely also estimate when you will be able to increase your savings rate. Your employer may conduct annual reviews. Your kids will graduate college by a certain date. Certain debt (mortgage, student loans, credit cards, etc.) will be paid off. You can reasonably assign odds to these events occurring by specific dates and make a plan to allocate the excess cash to savings. (Put a reminder in your smartphone to do so on the projected date. This will increase the likelihood of you actually allocating this cash to savings.)

Returns are trickier, but we can still assign some reasonable odds. Over the long term, large-cap stocks have realized an annualized return of 10%. Intermediate-term government bonds have returned about 5.1%. These are our baselines for making assumptions.

As long as we have an investing time horizon in excess of 10 years, we can reasonably expect the returns on stocks to be positive. [Large-cap stocks have only experienced losses on a rolling 10-year basis four times since 1926 according to the Ibbotson SBBI Yearbook (Duff & Phelps, 2017): 1929–1938, 1930–1939, 1999–2008 and 2000–2009.] We can adjust for the volatility of stocks by assigning an equal 25% probability of returns ranging between 3.5% and 7.5%, 7.5% to 12% and 12% to 16%. These are not precise, but they are more than close enough for assigning more nuanced odds. As far as the worse and better return outliers are concerned, stocks have been more likely to realize returns in the high teens than in the low single digits.

Bonds are admittedly a bit trickier because of current yields and the bull market they’ve experienced since 1982. Assuming yields on U.S. bonds don’t go below zero (which did occur in Europe), the potential upside for bonds is limited because yields are still low on an absolute basis. This is not an interest rate forecast, but rather a simple acknowledgement of math. Historically, the return on intermediate-term government bonds has been below the 5.1% geometric mean on more 10-year rolling periods than not. If you want to lean conservative, you could place the higher odds on long-term returns ranging between 1.5% and 3.5% and somewhat lower odds on returns between 3.5% and 6%. Assign an even lower probability on any return above these levels. Again, these are not exact odds, but close enough approximations based on historical data to use for planning purposes.

There is enough variance in the numbers for the projected dollar value of your retirement savings to vary depending on how you use the variables. If you add other assets to the mix, the returns will differ even more. (I’ll share more return data in next month’s AAII Journal.) Nonetheless, these numbers are arguably better for projecting how much in retirement savings you will have accumulated than uneducated guesses and forecasts dependent on a specific set of events occurring.

Like investing, forecasting is messy. Just because someone can precisely quantify the odds does not make their forecast better. You are far better off making simple assumptions based on what has happened historically, and adjusting your savings rate along the way, than relying on a specific forecast that could prove to be even more in error.

The Week Ahead

First-quarter earnings season will hit full steam with 184 members of the S&P 500 index scheduled to report. Included in this group are 12 Dow components: 3M Co. (MMM), Caterpillar Inc. (CAT), Coca-Cola Co. (KO), Travelers Companies Inc. (TRV), United Technologies Corp. (UTX) and Verizon Communications Inc. (VZ) on Tuesday; Boeing Co. (BA) and Visa Inc. (V) on Wednesday; Microsoft Corp. (MSFT) and Intel Corp. (INTC) on Thursday; and Chevron Corp. (CVX) and Exxon Mobil Corp. (XOM) on Friday.

The week’s first economic reports will be the April Purchasing Managers’ Index (PMI) composite flash and March existing home sales, both released on Monday. Tuesday will feature the February S&P Case-Shiller home price index, March new home sales and the Conference Board’s April consumer confidence survey. March durable goods orders and March international trade will be released on Thursday. Friday will feature the preliminary estimate of first-quarter GDP, April Chicago PMI and the University of Michigan’s final April consumer sentiment survey.

The Treasury Department will auction $32 billion of two-year notes on Tuesday, $17 billion of two-year floating rate notes (FRN) and $35 billion of five-year notes on Wednesday and $29 billion of seven-year notes on Thursday.

Courtesy of Charles Rotblut, CFA is the VP and Editor for American Association of Individual Investors (AAII). Charles is also the author of Better Good than Lucky. (EconMatters author archive here)  

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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