What is a reasonable real rate of return?

[ko]

There was a recent thread over on the bogleheads forum about what real rates people use for their planning that got me thinking about whether my assumption for my planning is reasonable. What real rate do you use (or would you suggest) with the following assumptions: an 80/20 or 75/25 portfolio and investing for 25-30 years (i.e. for someone now in their early 30s).

I was surprised to see that most folks over on the other thread were saying they would use a 1% to 2.5% real rate, with a few outliers saying they use 3% to 4.5% (and maybe one person saying they'd use 5%+). There were lots of cautions to not use anything too optimistic, which seems to them to be anything more than 1.5% or 2.0%.

Does that seem right to you? What do you use? If a real rate of 2.0% to 2.5% or so really is realistic, it seems pretty challenging for most people (including a lot of medium- and high-income earners) to comfortably get to a point where they can retire with $100k or $120k per year coming from their investments (using a 4% or 3% rule for the required size of a portfolio at retirement), particularly if they want to do it before age 60 or so.

Thoughts?

[PhysicianOnFIRE]

1% to 3% is fairly pessimistic, but certainly in the range of possibilities, particularly over the short to intermediate term, say 5 to 10 years.

When I crunch numbers for retirement planning, I look at a range of possibilities from 0% to 6% or more (see example here).

To reach the retirement target you mentioned would require a nest egg of about $3 million, depending on which numbers you use.  Setting aside $110,000 for 22 years at 2% a real return will get you there.  The lower your savings rate, the longer it will take, obviously.

 

 

[Zaphod]

PhysicianOnFIRE wrote:

1% to 3% is fairly pessimistic, but certainly in the range of possibilities, particularly over the short to intermediate term, say 5 to 10 years.

When I crunch numbers for retirement planning, I look at a range of possibilities from 0% to 6% or more (see example here).

To reach the retirement target you mentioned would require a nest egg of about $3 million, depending on which numbers you use.  Setting aside $110,000 for 22 years at 2% a real return will get you there.  The lower your savings rate, the longer it will take, obviously.

 

 

Click to expand...

Agree with this. There is a huge demographic change currently that will start to draw down their pensions and retirements that possibly may depress gains for 5-10 years as they sell to us smaller Gen X'ers, and some point in the future Millenials will enter their peak earning years and us Xers can sell to them at a premium, *maniacal cackle*.

This is actually a pretty good scenario if you're accumulating. You get in at a fairly even basis and the lack of great initial gains makes you very focused on savings. Of course it only turns out amazing if at some point after it has a banner period, heres hoping.

Sometimes we may forget to put it out there explicitly, but if anyone is describing or planning for the future with anything other than a range of possible results than something is very amiss.

[The White Coat Investor]

Some of those threads on Bogleheads are kind of silly. You get people comparing how low they can go like its a limbo contest. I use 5% real for my planning for an aggressive stock/bond portfolio. It has worked well so far. Until last month, I was exceeding that over the long term. When you get into the 1-2% range, it changes everything as discussed here:

https://www.whitecoatinvestor.com/making-different-choices-due-to-low-expected-returns/

[The White Coat Investor]

Zaphod wrote:

PhysicianOnFIRE wrote:

1% to 3% is fairly pessimistic, but certainly in the range of possibilities, particularly over the short to intermediate term, say 5 to 10 years.

When I crunch numbers for retirement planning, I look at a range of possibilities from 0% to 6% or more (see example here).

To reach the retirement target you mentioned would require a nest egg of about $3 million, depending on which numbers you use.  Setting aside $110,000 for 22 years at 2% a real return will get you there.  The lower your savings rate, the longer it will take, obviously.

 

 

Click to expand…

Agree with this. There is a huge demographic change currently that will start to draw down their pensions and retirements that possibly may depress gains for 5-10 years as they sell to us smaller Gen X’ers, and some point in the future Millenials will enter their peak earning years and us Xers can sell to them at a premium, *maniacal cackle*.

This is actually a pretty good scenario if you’re accumulating. You get in at a fairly even basis and the lack of great initial gains makes you very focused on savings. Of course it only turns out amazing if at some point after it has a banner period, heres hoping.

Sometimes we may forget to put it out there explicitly, but if anyone is describing or planning for the future with anything other than a range of possible results than something is very amiss.

Click to expand...

There are billions of people in other countries ready and willing to buy those stocks from the Boomers. I do NOT think this is a significant cause of lower stock returns in the future. A better boomer-related reason is that lots of people come out of the workforce and GDP drops. But again, there are far more people on this planet than just Americans and they'll step in and pick up where the boomers left off. There are 76 Million baby boomers. There are what, 7 Billion people on the planet? Seems kind of trivial now, doesn't it? Besides, those boomers aren't selling all those equities all at once. Many will die and pass them on to kids. Others will sell a little each year over 20 or 30 years etc. It's just not a big factor and I wouldn't spend any time worrying about it.

[Zaphod]

I think the same thing about the growth of revenues in US companies, now they can grow to the rest of the world possibly so what we consider as market cap limits, revenues, earnings, etc...may not hold. The US is very small after all. Lets hope that works out, its definitely a nicer overall scenario.

[ko]

The White Coat Investor wrote:

Some of those threads on Bogleheads are kind of silly. You get people comparing how low they can go like its a limbo contest. I use 5% real for my planning for an aggressive stock/bond portfolio. It has worked well so far. Until last month, I was exceeding that over the long term. When you get into the 1-2% range, it changes everything as discussed here:

https://www.whitecoatinvestor.com/making-different-choices-due-to-low-expected-returns/

Click to expand...

I just read the Wade Phau blog post you linked to in your own post that you referenced above - it looks like that when he says 2% real is his planning estimate, he's rounding down from a 2.95% that he gets from Joseph Tomlinson. This 2.95% figure is 1) based on a 50/50 portfolio, and 2) adjusted down for market conditions in 2013.

So I guess what I'm saying is that Wade Pfau's 2% estimate is particularly conservative (or pessimistic, if you like) for someone like me that is in their early 30s in 2016, right? I agree that a range of expected return rates is the best way to go, but 2% seems very low following his own logic, no?

 

[PhysicianOnFIRE]

Wade Pfau is known for being very conservative.  I've read his safe withdrawal rate articles, where he advocates a SWR closer to 2% but also assumes management and investment fees of about 1.5%, which is about 1.4% higher than a savvy DIY investor will spend.

I just read the referenced blog post.  It is one prediction from one intelligent man, but there are many others who expect returns to be at least a little bit better than that.  He might be closer to correct than Dave Ramsey, who unapologeticly uses 12% as the expected rate of return.

[Zaphod]

PhysicianOnFIRE wrote:

Wade Pfau is known for being very conservative.  I’ve read his safe withdrawal rate articles, where he advocates a SWR closer to 2% but also assumes management and investment fees of about 1.5%, which is about 1.4% higher than a savvy DIY investor will spend.

I just read the referenced blog post.  It is one prediction from one intelligent man, but there are many others who expect returns to be at least a little bit better than that.  He might be closer to correct than Dave Ramsey, who unapologeticly uses 12% as the expected rate of return.

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Maybe he's confusing his rate of return for you buying his promoted managers.

[TheGipper]

I am still 20+ years out from retirement, so trying to figure what annual spending I will need/require is a bit of a joke but I do enjoy planning and the various calculators and spreadsheets out there.

I always plug in a nominal return of 5% for equities and 2.5% for bonds for my 80/20 portfolio.  I plan to stay at 70/30 at retirement, 100/0 in Roth.  I'm sure this would equate to a pitiful real rate, but the way I view it, my overly pessimistic input for returns is more than balanced out for the other risks such as gaps in working, health issues, new job not allowing for as much tax deferred space, more support of aging parents or kids than anticipated as well as risks I can't even think of.

Interestingly, my favorite calculator, i-orp starts with default of 6% and 3% nominal.

Keeping expectations low motivates me to keep maximizing my savings rate to reach my goals.

If I had to guess, I do think that the bogleheads (and Bogle's own predictions for long term stock and bond returns) are closer to correct than WCI's. Admittedly, I have zero academic research or evidence to back this up.

If I'm wrong, the worst that has happened is that I've oversaved.  I am not (yet) in the depserate to retire early crowd anyway.

[CFEonline]

Curious what is the going wisdom on a conservatively realistic rate to use for FV / PMT calculations. Any changes from what people were thinking 3.5 yrs ago?

[ENT Doc]

I use 4% real.  Future tax increases are going to do more damage than people realize.

[CM]

ko wrote:

There was a recent thread over on the bogleheads forum about what real rates people use for their planning that got me thinking about whether my assumption for my planning is reasonable. What real rate do you use (or would you suggest) with the following assumptions: an 80/20 or 75/25 portfolio and investing for 25-30 years (i.e. for someone now in their early 30s).

I was surprised to see that most folks over on the other thread were saying they would use a 1% to 2.5% real rate, with a few outliers saying they use 3% to 4.5% (and maybe one person saying they’d use 5%+). There were lots of cautions to not use anything too optimistic, which seems to them to be anything more than 1.5% or 2.0%.

Does that seem right to you? What do you use? If a real rate of 2.0% to 2.5% or so really is realistic, it seems pretty challenging for most people (including a lot of medium- and high-income earners) to comfortably get to a point where they can retire with $100k or $120k per year coming from their investments (using a 4% or 3% rule for the required size of a portfolio at retirement), particularly if they want to do it before age 60 or so.

Thoughts?

Click to expand...

For US stocks: The dividend yield plus the LT real growth rate of earnings (1.25% according to Siegel, and about 1.5% according to Arnott, and about 1.55% from Shiller's spreadsheet IIRC) minus a haircut for a fall in valuation. That is, I apply a PE10 of 15 to 20 at my horizon of interest. That change (i.e., decline) in valuation is very important over short horizons, but less so over long horizons.

For bonds: The real yield on TIPS.

[CM]

ko wrote:

So I guess what I’m saying is that Wade Pfau’s 2% estimate is particularly conservative (or pessimistic, if you like) for someone like me that is in their early 30s in 2016, right?

Click to expand...

Your age doesn't change expected returns.

The real yield on TIPS is what it is, and the returns to stocks depend on the dividend, real growth, and the valuation at your horizon of interest. Growth and the future valuation may be higher or lower than historical means, and you are free to make your own projections.

In my opinion, the future valuation is likely to be higher than the historical mean (lower transaction costs, greater transparency, tighter regulation), but still much lower than today.

On the other hand, I'll be surprised if growth matches the historical rate. Profit margins have been at record highs for years now and I don't believe this is a new, permanent plateau.

[StarTrekDoc]

If any of the interest rate talk is a clue --- we're in a state of low inflation and rates of return, with a real possibility of return to recession and limited bullets to jump start the economy this time with rates already at 2.25% after a CUT while STILL in a growth economy.   That's kind of scary IMHO.

Traditional real 5% was a good level for a 80/20 portfolio.   I don't know if that's realistic anymore.  Certainly a 2% real is extremely conservative and I wonder those believing that 2% real on how they anticipate SOR.

For those just entering their savings career, this is going to be hard with compounding effects blunted.

I totally agree with @ENT Doc.  Tax rates are in a sweet spot these years and anyone in the 24% bracket should really consider ROTH as I don't see these brackets sustainable and will sunset at 10 years and return to the higher brackets again--affecting those doing pretax deferred payments.