Looking to plan for your financial future? The rate of return estimate you start with can make all the difference in the success (or failure) of your investment. While it may seem daunting to predict the future with confidence, it’s vital for you to determine what return percentage you expect to receive before designing your financial or retirement plan.
The Right Number For The Right Times
Let’s take a look at the number you (or your advisor) are currently using. Are you still investing like it’s 1999 and expecting to get 12 per cent? Or are you like a deer in the headlights, satisfied with keeping your savings safe, happy to earn 0 per cent? (Hello - that’s not much of a plan!)
Getting The Number Right
As an advisor, establishing realistic expectations for my clients’ savings and for my professional performance is one of the most important aspects of planning. Without a realistic number, my clients’ financial plans would be useless and their satisfaction with me would be short lived. Things to consider:
- Set your expectations too high (say 12 per cent) and you will be disappointed as your plan becomes irrelevant.
- Set them too low (say 2 per cent) and you may find your plan has you working until you’re 80.
The hardest part about picking the right number is that no one has a crystal ball. No one knows which investments will perform best over the next 5, 10 or 20 years, whether it’ll it be stocks, bonds, cash, real estate or some combination of those.
How Can You Plan Your Investment’s Performance?
To gain pro insight on reasonable future investment estimates, I always look at the report card (actuarial report) written up for large pension plans.
Why? For a few good reasons:
- Pension plan investments are managed by highly skilled, educated and experienced teams of professionals. (In the investment world these investment pros are often called the Smart Money.)
- Pension investments are managed with a long-term perspective and take into account numerous bull-bear stock market cycles, boom-bust economic cycles, and social/political cycles.
- Pension investments are managed with the understanding that they must support the plan’s future financial obligations to its pensioners.
- Pension plan administrators must maintain realistic expectations for the investment returns generated if the plan is going to succeed in the long run.
The Proof Is In The Pension Plan
Let’s look at a recent example in the case of the actuarial report completed by the Office of the Superintendent of Financial Institutions Canada for the Pension Plan For The Public Service of Canada (one of Canada’s largest pension plans), published in May of 2012.
In their report, the Office of the Chief Actuary outlined the pension plan’s investment expectations (i.e. rate of return) for the next 5 years as follows:
- Long-term bonds will have an average annual real yield of 2.70 per cent
- Stocks will have a real return of 4.1 per cent, and
- Real estate and infrastructure will generate a real return of 3.1 per cent
Note: The stated real yield and real returns are after deducting for inflation.
Breaking Down The Numbers
Another fact gleaned from the report is the expected average annual real return for the plan’s investments, which are estimated to be 3.64 per cent for the next 5 years.
This 3.64 per cent expected return is based upon the pension plan’s asset allocation, which at present includes:
- 66 per cent invested in stocks
- 21 per cent in fixed income
- 13 per cent in real estate and infrastructure
So, if these numbers are good enough for the Smart Money, with all of their skill, education and experience, they should be good enough for us.
Note: If your investment portfolio uses a different asset allocation, then your expected real return should be higher or lower than the 3.64 per cent – above 0 per cent, but below 4.1 per cent.
What Does This Mean For The Rest Of Us?
Given the current rocky state of financial affairs, the guys that wrote this report are being realistic and are not shooting high. And if we want to avoid financial disappointment, we’d be wise to follow their lead, which means this:
- If the success of your current financial plan is dependent upon numbers like 12 per cent or even 8 per cent rates of return, you might want to revisit your plan.
- If you’re invested 100 per cent in the stock market, you might want to go back to your financial plan and plug in the 4.1 per cent they use and see what you get.
Remember: It’s way better to pick realistic numbers today than face the disappointing numbers in the future. In a world with no crystal balls, your best bet is to follow the lead of the Smart Money.