Discover the “Real” Rate of Return You Must Earn
Would you take a potent new drug because a television personality was discussing it last night?
Of course not! When stated like that, it seems absurd.
However, this is what the majority of Americans do with their investments.
They read a magazine article, listen to a call-in talk show, or meet with an investment salesperson and become mesmerized by the latest and greatest “Can’t Lose” investment gadget without first figuring out what they need to earn from the investment in the first place.
If asked, most Americans approaching their retirement years do not know the rate of return they must earn on their Retirement Bucket™ of investments. They know what they’d like to earn, but they don’t know what they must earn.
Don’t get lazy and fall into this trap. Do whatever is necessary to discover the “real” investment rate of return you MUST earn first so you have a target!
How Do You Find the Rate YOU Must Earn?
The real investment rate of return you must earn during your retirement phase of life is dependent on three factors:
- Your Level of Retirement Bucket Dependence™: how much money you need to withdraw from your Retirement Bucket™ each year to supplement your social security, pensions, and rental property income (if you own rental property), so you can live exactly the way you want.
- The Size of your Retirement Bucket™: the amount of money you’ve accumulated over your lifetime to draw from to provide this supplemental income, and
- Inflation: This is the biggest factor as you will see in a moment.
The good news for you is that we’ve discussed how you can determine your level of Retirement Bucket Dependence using steps one and two of The Relaxing Retirement Formula™ over the last few weeks.
Have you determined your level of Retirement Bucket Dependence™?
If not, I can’t urge you enough to take these initial steps if you want the confidence to spend what you’ve taken your entire life to accumulate without fear.
Calculating the size of our Retirement Bucket™ comes down to you having accurate and up-to-date statements on all of your bank and investment accounts. Given that we’re in February, you should be able to put your hands on February 28, 2020 statements rather easily.
That brings us to #3: inflation.
As we discussed recently, when it comes to inflation, you have to make some assumptions as to what you believe the rate of inflation will be in the future.
I strongly recommend that you assume a higher rate of inflation than the present to be conservative.
The reason for this is simple. You have no control over the rate of inflation. If you assume a low rate of inflation, as we’ve experienced for the last decade or so, and inflation ends up being higher, you’re going to run out of money sooner than you planned.
On the other hand, if you estimate a higher rate, and inflation ends up lower than you planned for, you’re still in great shape!
Getting back to Steps One and Two, once you know your level of Retirement Bucket Dependence™, i.e. the amount of money you need to withdraw from your investments each year to keep pace with inflation, and you know the amount of money you’ve accumulated in your Retirement Bucket™, the rate of return you “need” to earn is the rate that allows your money to remain intact for the remainder of your life while continuing to generate the lifestyle sustaining cashflow you need each year.
Nominal vs. “Real” Rate of Return
The key point to understand is that the investment rate of return you need to earn, commonly referred to as the “nominal” rate of return, is in direct relation to the rate of inflation you assume.
For example, if you assume an inflation rate of 4%, and then calculate the investment rate of return you need to be 6.5%, then you need to earn 2.5% above inflation.
This is known as the “real” rate of return.
If inflation turns out to be 5%, then you would need to earn 7.5%. (2.5% above inflation)
The rate you must discover is the “real” investment rate of return you need to earn, i.e. after taking your assumed inflation rate into account.
Can you see why you must know this?
If you have a large Retirement Bucket™, and you only need to withdraw a little bit each year for your supplemental income needs (like Mike and Mary Independent in our case study over the last few weeks), you probably don’t need to earn a very large rate of return.
On the other hand, if you need to withdraw a lot of money each year from your Retirement Bucket™ (like Ron and Rose Reactionary), you may need to earn a much larger rate of return.
Either way, you must know what your “real” rate is!
If you don’t, it’s the equivalent of a surgeon opening up your body before knowing if you even have a disease, or where it’s located.
You may very well be investing more aggressively than you need to and subjecting yourself to far more volatility than you need to.
And, even more importantly, if you don’t know the rate you need, you may be investing too conservatively and run out of money because your Retirement Bucket™ isn’t growing fast enough to keep up with your spending needs.