For the last couple months, I have been carrying around an article from The Wall Street Journal that I have wanted to discuss with you; an important topic for those of us who want to reach our financial goals, ignore Wall Street, and get on with our lives. 

The article, dated September 18, 2010, is titled “PENSION GAP LOOMS LARGER – funds stick to unrealistic returns assumptions, threatening bigger shortfalls.”  (Registration might be required to access the article)

It discusses the danger of using unrealistic portfolio growth assumptions when calculating future returns.  The article reveals that the median of more than 100 surveyed pension funds use an average 8% projected return, even though these same pension funds haven’t come anywhere near securing those returns over the past 10 years and longer. 

To be blunt, if you use a portfolio rate of return in your financial projections on your portfolio that is likely too high, it increases the chances that you won’t reach your financial goals in a timely manner.

For example, I am 50 years old, and I want to see how much money I need to save each month so that my wife and I can retire when we are 70.  Using my favorite financial planning software, I calculate that I have to save about 33% more over the next 20 years by using a portfolio growth rate of 5% instead of 8% (For the sake of this exercise, I left all other variables constant). 

In calculating this exercise, I am keeping a few things in mind . . .

  • It is essential that I run this portfolio projection exercise at least once a year.  It keeps us on track in light of the many variables that will be thrown our way, both from a portfolio returns standpoint and lifestyle standpoint.  If the years go by and our portfolio is returning more than 5%, it means we can save less.  The flip side is true if our returns are less than 5%.
  • Even though The Coffeehouse Investor portfolio has significantly outperformed the 5% projection over the past ten years, I am not counting on it to outperform in the future, which invites me to focus on my savings rate as the primary factor in reaching my financial goals.   
  • One of the primary benefits of integrating low-cost index funds into our diversified portfolio is that IF the markets perform better than my 5% estimated return, I am certain to capture it, as Coffeehouse Investors did over the past ten years!   

My wife and I have decided it is far better to use a lower projection rate, and save a little more, than to come up short when we are 70 and expecting to retire, because we have been overly optimistic in our projection returns.   

This is especially important if a financial institution generates projections for you.  I recently came across an example of a husband and wife who showed me a worksheet created for them by a nationally known firm out of Boston, who also used 8% in the worksheet.  The resulting scenario was a pie-in-the-sky projection that was incredibly misleading to this couple’s financial well-being.

What rate of return do you use in your financial projections?  What is your reasoning behind choosing that figure?  Anything else you want to discuss on this topic?  Send us your comments, and we will post for all to discuss.