The One Investment You Need Most For A Successful Retirement
Whether you’re still building your nest egg or tapping it for income, you need to re-evaluate your investing strategy in light of lower projected investment returns in the years ahead. The upshot: Unless you’re putting most of your money into low-cost index funds and ETFs, you may very well be jeopardizing your shot at a secure retirement.
As if we needed more confirmation that future investment gains will likely be anemic, investment adviser and ETF guru Rick Ferri recently unveiled his long-term forecast for stock and bond returns. It’s sobering to say the least. Assuming 2% yearly inflation, he estimates stocks and bonds will deliver annualized gains of roughly 7% and 4% respectively over the next few decades. That’s quite a comedown from the 10% for stocks and 5% or so for bonds investors had come to expect in past decades.
Given such undersized projected rates of return, you can’t afford to give up any more of your gain to fees than you absolutely have to if you want to have a reasonable shot at attaining and maintaining a secure retirement. Which means broad-based index funds or ETFs with low annual expenses should be the investment of choice for individual investors’ portfolios.
Here’s an example. Let’s say you’re 25, earn $40,000 a year, get 2% annual raises and plan to retire at 65. Back when stocks were churning out annualized gains of 10% and bonds were delivering 5% yearly, you might reasonably expect an annualized return of 8% or so from a 60% stocks-40% bonds portfolio. Assuming 1.25% in annual expenses—about average for mutual funds, according to Morningstar—that left you with an annual return of roughly 6.75%. Given that return, you would have to save about 11% of salary throughout your career to end up with a $1 million nest egg at retirement.
But look at how much more you have to stash away each year if returns come in at current low projections. If stocks return 7% annually and bonds generate gains of 4%, a 60-40 portfolio would return roughly 6%. Deduct 1.25% in expenses, and you’re looking at an annualized return of 4.75%. With that return, the 25-year-old above would have to save 17% of salary annually to accumulate $1 million by age 65. In short, he would have to increase the percentage of salary he devotes to saving by almost 55% each year, enough to require a major lifestyle adjustment.
There’s not much you can do to boost the returns the market delivers. But you do have some control over investment expenses. Suppose that instead of shelling out 1.25% a year in expenses, our 25-year-old lowers annual costs to 0.25% by investing exclusively in low-cost index funds and ETFs. That would boost his potential return on a 60-40 portfolio by one percentage point from 4.75% to 5.75%. With that extra percentage point in return, our hypothetical 25-year-old would be able to build a $1 million nest egg at 65 by saving 13% of salary annually instead of 17% year. Granted, 13% is still more than the 11% he had to save when he was paying 1.25% annually in expenses and stocks and bonds were delivering higher historical rates of return. But investing low-fee index funds and ETFs clearly gives him a better shot at building a seven-figure nest egg than he would have with funds that charge higher expenses.
Holding the rein on expenses in the face of expected subpar returns is just as important when you’re tapping your nest egg. For example, if you follow a systematic withdrawal system like the 4% rule—i.e., draw 4%, or $40,000, initially from a $1 million 60% stocks-40% bonds portfolio and increase that amount each year for inflation—reducing annual expenses by a percentage point will significantly increase the probability that your nest egg will last 30 years or more.
Can I guarantee that you’ll be able to duplicate these results exactly? Of course not. Given the choices in your 401(k) or other retirement accounts, you may not be able to reduce expenses as much as in these scenarios. Even if you can, there’s no assurance that every cent you save in expenses will translate to an equivalent gain in returns (although research shows funds with lower costs do tend to outperform their high-cost counterparts).
And let’s not forget that we’re dealing with projections here. They may very well get it wrong. Even if they’re spot on, you won’t earn that annualized return year after year. Some years will be higher, others lower, which will affect both the size of the nest egg you accumulate as well as how long it will last. It’s also possible that you may be able to generate a higher return than the market ultimately delivers (although doing so typically means taking on more risk).
But the point is this: If returns do come in lower than in the past—which seems likely given the current low level of interest rates—the more you stick to low-cost index funds and ETFs, the better the shot that you’ll have at accumulating the savings you’ll need to maintain your standard of living in retirement, and the more likely your savings will last at least as long as you do. (4/14/15)
Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at firstname.lastname@example.org.