Last Updated Mar 21, 2011 8:57 AM EDT
That's about double the "new normal" returns we were told to prepare for in the wake of the financial crisis. And the nation's largest public pension, CalPERs, recently announced it is sticking to a robust 7.75 percent assumed overall portfolio rate of return. That's more than three percentage points higher than what it managed to earn the past 10 years.
So does that mean you and your 401(k) can relax a bit, knowing that higher returns will do more of the heavy lifting in the coming decade? Well, it's not that simple. As enticing as it is to hitch your retirement wagon to a rosy return assumption, the smart investment move is to respect the fact that no matter how compelling the data may be, no matter how smart the forecaster is, assumptions are just guesses, not guarantees.
Some points to consider before you make the fateful decision on what assumed rate of return to plug into your retirement calculations:
- Sure, Pimco could be wrong about low returns. The venerable investing duo of Bill Gross and Mohammed El-Erian have been resolute that we should plan on "half-size returns" of 4 or 5 percent going forward as slower economic growth will impinge corporate profitability and thus put a damper on market returns. The new study from the Center for Retirement Research at Boston College begs to differ. It makes a case that strong corporate profitability can fuel stock market returns in the coming decade that are in line with long-term historical trends, even without strong economic growth.
"Corporations can increase the assets backing each share of their stock without installing new plant and equipment by using their earnings to purchase equity in other companies, to buy their own stock, or to retire debt. Like the installation of new capital assets, these financial investments can boost earnings per share."
The CRR study suggests a 6.5 percent inflation adjusted return for stocks is plausible. (That real return subtracts inflation from the gross market return. A 6.5 percent real return is in line with a nominal market return of 10 percent.)
- Or Pimco could be very right. The CRR study is, after all, just another well-considered guess that is captive to its own assumptions. For example, a core premise of the study is that the S&P 500's current price-earnings multiple is right in line with its long-term historical average of 15, suggesting the market isn't overvalued. But one much-followed school of thought is that a better barometer is to measure p/e based on earnings over the past 10 years, not just the most recent 12 months. The Shiller p/e does just that, and it is currently sitting at 23.6, which is well above its long-term average of about 16.
- Ignore public pension return assumptions. The fact that most public pensions use an assumed rate of return of more than 7 percent is in part a function of political -- not investment-related -- considerations. Public pensions like to set high assumed rates because it makes the pension appear more "funded" than it would be at a lower assumed rate. That's pretty much why CalPERs recently decided to stick with 7.75 percent rather than follow the advice of its own actuary to use a 7.5 percent rate. Bill Gates, whose foundation's education initiatives are impacted by state finances, recently described the investment assumptions made by public pensions as being a "fiction."
- The value of using a conservative return assumption. I'm rooting for the CRR at Boston College to be right, and the new normal gang to be wrong. I bet the new normal guys are wishing the same. But what we hope will happen is irrelevant. And overconfidence is retirement planning kryptonite. This is where 17th-century 401(k) investment guru Blaise Pascal can be a huge asset. He came up with the theory that a prudent strategy in the face of uncertainty is to position ourselves to be OK no matter what the eventual outcome may be. According to Pascal's Wager, the most important investing consideration is to always ask yourself: What if my assumption is wrong?
So if you assume 10 percent returns and in fact the market returns 5 percent, you'll likely be sweating bullets come retirement time. But if you instead assume 5 percent returns and the market returns 10 percent, no harm, no foul. All you've done is give yourself a bunch of fabulous options. You can afford to save less later on, you can maybe step down to a less demanding and less lucrative job in your 60s, or you could even retire earlier than expected. Nice problems all.
- Time for a retirement recalculation. The bottom line is that your future is riding on the quality of your return assumptions. Or more to the point, the assumptions plugged into the popular online retirement calculators offered by the likes of Fidelity, T. Rowe Price, and Vanguard. All three use Monte Carlo simulations that model a variety of potential outcomes. But they, too, have to start with a basic assumption. Fidelity and T. Rowe Price start with the long-term historical average returns, so that's 10 percent or so for stocks, and 5 percent for bonds. Vanguard puts you in the driver's seat and has you set your own expected portfolio rate of return; 6 percent is framed as conservative and 9 percent as aggressive. Those are all sound assumptions based on long-term Ibbotson data going back to 1926. But just because we know the average of the past 84 years doesn't tell us much about what can happen over the next 10 years.
And that's what makes planning your own retirement so insanely difficult. What's the right rate of return to assume? I'd take a look at how things look using a low rate of return. Adjust your plan in light of that possibility and your biggest risk is that if things do turn out better than your assumptions you may end up with more money and more options. That's the bet you want to take.
Photo courtesy Flickr user miggslives
More on MoneyWatch