Overlooking a single aspect of a retirement savings plan has the potential to compound into a poor financial position later in life.
Saving for retirement is a complex multidecade endeavor. The opportunities to make a mistake along the way are plentiful. But this single pitfall could be the most detrimental of all.
Many people overestimate the returns their retirement portfolio will generate.
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How much can you really expect?
I've seen experts tout that you can expect anywhere between 8% per year to 12% per year in returns from your retirement portfolio. The truth is you should expect much lower returns.
The S&P 500 index has produced a real compound annual growth rate of just 6.5% per year (including reinvested dividends) since 1928. The biggest culprit of that lower rate of return is inflation. Without accounting for inflation, the S&P 500 produced a compound annual return of 9.7%.
Things don't cost what they used to. And things in retirement 30 years from now won't cost what they do today.
Real returns have remained fairly steady. The real compound annual growth rate for the 35 years ended in 2022 was less than 7.5%. The average 35-year CAGR rate since 1945 is 6.6%.
If you're overestimating the real returns you can achieve in your retirement portfolio, you're setting yourself up to fall well short of your retirement needs.
Consider the value of $250 saved and invested every month for 35 years. With a 10% rate of return, those savings would grow to nearly $950,000. However, with the 7.5% mentioned above, the total would fall to just $508,000. Take it down to the 6.5% seen over the past century, and the final amount barely clears $400,000.
Earning just 6.5% on your investments can leave you with significantly less money to spend in retirement than you might have planned for.
If you're not accounting for the impact of inflation on your returns, you'll really have to strain your budget in retirement.
Don't forget, your portfolio should change over time
It's a common strategy to adjust your asset allocation as you near retirement, and that will have an impact on your expected returns.
At some point, you need to ensure you preserve what you've worked so hard to save. That necessitates adding diversifying assets to a stock portfolio like bonds. That will help ensure a big downturn in the stock market right before you retire won't completely wipe out your retirement plans.
But bonds don't produce the same returns as stocks.
Even if you were using a steady 6.5% real rate of return for your retirement savings, you may still be overestimating your actual results. Maybe you'll earn those returns in the early days of your retirement savings, but as you add more bonds, your expected returns will go down. You need to account for the reduced returns in your retirement savings plan.
The financial markets don't produce steady returns
The sequence of returns you earn on your retirement savings can have a massive impact on your final portfolio value too.
You know the stock market doesn't produce the same returns month after month. And the returns your portfolio generates at the end of your retirement savings plan will have a much bigger impact on the final value of your portfolio than the returns early in your career. That's because you'll have much more money in the markets as you near retirement.
So, if your retirement savings plan revolves around a single steady return number, you may not be saving enough.
How to avoid the pitfall
The key to avoiding the pitfall is to incorporate realistic returns into your retirement savings plan.
The first adjustment to make is to set expected returns for your retirement portfolio over time. You can expect strong (but not too strong) returns early in your career when you invest primarily in stocks. You should expect more moderate returns as you approach retirement and add assets like bonds.
Additionally, remain mindful of sequence of return risk. Shifting toward diversifying assets as you approach retirement is key to mitigating the impact of sequence of returns, but it won't entirely offset the impact of a bad decade of stock returns leading up to retirement. You may also want to increase your retirement savings goal and be OK with falling short of that mark.
The last thing to remember is that you should update your plan as you go through life. Sticking to a single retirement savings plan you developed in your 20s or 30s will likely fail to produce results as good as revisiting your savings plan every few years. You need to be able to adjust to the results the market gives you and any life changes.
Put simply: save more now and adjust later.
