Compounding the problem

Are you saving for retirement? Great. But here’s an equally important question: what kind of returns are you envisioning in your portfolio?

Financial guru Manisha Thakor pointed me toward an interview that ran in the WSJ recently with Robert D. Arnott, a portfolio manager. Looking at demographic trends and the maturing of the US economy, he made the case that US stocks would have “a forward-looking return of 5%, give or take, over the next 10 to 20 years.”

Obviously, no one can predict the future. In All the Money in the World, I mention an economist, quoted in Money magazine in 1988 as a total outlier, predicting the Dow would close at the end of the 1990s at 5000 or 6000. It actually closed on December 31, 1999 at 11,497.We could see a technological or policy revolution that could spur similar growth.

But the opposite prospect — of relatively low returns — raises a question for people making retirement calculations. What return are you banking on? Because there is a huge difference between 5-6% returns and the 10-12% returns that some personal finance types tell you that you can get:

• Invest $3000 a year for 40 years at 5% interest and you get $401,639.26

• Invest $3000 a year for 40 years at 10% interest and you get $1,596,333.20

Financial planners often recommend living on about 4% of your assets per year, to avoid outliving your money (a real fear as people start to live, regularly, into their 90s). If you’re trying to live off 4% per year in retirement, the first nest egg gives you $16,000 a year. With Social Security, you’ll make it, but you won’t be living in high style. The second nest egg gives you a far more comfortable $64,000 (roughly). This starts to enable the kind of retirement people picture, with travel, hobbies, potentially helping with grandkids’ expenses, etc.

In both cases, people saved the exact same amount. But the outcome is very, very different. And the unfortunate truth is, while you might be able to do a little better (or a little worse) than the market on the margins, in the long run few people do beat the market. Professional fund managers don’t. Potentially you can juice returns with emerging market equities, but if you’re trying to create a balanced portfolio with some bonds, that will put downward pressure on returns.

As Manisha pointed out on Twitter (@ManishaThakor), all you can control is the amount you save. Saving $9,000 a year for 40 years at 5% interest gives you $1,204,917. This bears repeating: If you want a good chance of having lots of money saved, you need to save lots of money. As Kim Palmer (@AlphaConsumer) responded, you can also control how long you work. In the first nest egg scenario (the $400,000 one), if you earn $15,000 a year at a part-time job or freelancing during your semi-retired years, you’ll be much better off than if you live solely off 4% of your nest egg and Social Security.

As I’ve written here before, I think that the whole idea of retirement needs a rethink. Low returns as the demographic bulge of the Baby Boom exits the workforce is at least one of the reasons.

This post is part of Women’s Money Week 2012. For more posts about saving and investing see the Saving and Investing Roundup.