Expected Rates of Return on Retirement Investments

In retirement, we expect to live on the wealth we have accumulated throughout our working lives. We do that by withdrawing wealth for current consumption, to replace the flow of earned income that dried up with retirement. The size and duration of these withdrawals depends on two things – the amount of accumulated wealth we have at retirement and the rate of return earned during retirement. Wealth accumulation attracts a vast amount of attention from analysts, advisors, and self-styled pundits. Surprisingly, the retirement rate of return is treated very superficially.

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Historic Rates of Return

Data on historic classes of assets have been compiled by reliable researchers such as Ibbotson Associates. We should not apply historic averages – compiled over many decades – to short time periods. Retirements have been starting earlier, life expectancies have been lengthening, and the average length of retirement has lengthened as well. This has tempted some retirement planners to use historic rates of return in calculating current rates of return. Unfortunately, this is a questionable practice.

It is reasonable to suppose that a diversified equity portfolio will approximate the long-run return on equity over two or three decades of saving for retirement because the portfolio is growing, new shares are constantly being purchased, and any decline in portfolio value during times of falling prices is offset by the value of inexpensive shares purchased at low prices. Moreover, workers are still working and consequently have the chance of recouping investment losses.

Saving while in retirement is a different matter. During retirement, a market downturn and consequent loss of portfolio value that would have been shrugged off during working years can become a major setback. Now the retiree is not investing, only consuming. He or she cannot replace lost principal value by working and contributing replacement dollars. New investments cannot exploit low share prices to replenish the portfolio with inexpensive shares. Instead, the retiree will continue to withdraw wealth from the portfolio even during the downturn, thus accentuating its effect. Thus, retirement rates of return will likely fall short of historic rates.

The Ibbotson Associates Data

Nevertheless, long-term historic rates of return are useful as a point of departure when estimating retirement rates of return. Consider these rates, calculated by Ibbotson Associates based on data from 1926-1996:

  • Small stocks: 12.5%
  • Real estate: 11.1%
  • Large stocks: 10.0%
  • Bonds: 5.2%
  • T-Bills: 3.7%
  • Inflation: 3.0%

70 years certainly seems like a sufficient time span from which to draw conclusions. Before incorporating these returns in planning forecasts, however, consider the following. These are before-tax returns, assuming reinvestment of dividends. The time span includes numerous periods in which one or more of the above returns were unrealistically high or low. Some of these extremes were due to marketplace fluctuations, but many of them were due to manipulation of economic variables by governments. (For example, interest rates were “pegged” at artificially low levels in the U.S. during much of the 1950s and 1960s by deliberate government policies. This not only affected bond rates of return, but stock prices as well.) While we may be able to draw conclusions about the frequency and severity of “natural” economic events (recessions and depressions, say) over long time frames, there is no way to do the same for events caused by governments.

Should We Use the Ibbotson Table to Forecast Retirement Rates of Return?

The most striking thing about the above table is the high rate of inflation. 3% is a very high average annual rate over so long a time period; it implies a doubling of the general level of prices every 24 years. (In comparison, the price level remained roughly level over the 19th century.)

This accounts for the other striking anomaly, which is the superiority of real estate to large stocks. During inflation, people tend to forsake financial assets because the purchasing power of their returns is declining. This applies even to stocks, whose true relative values become obscured by inflation. Price increases tend to affect some firms more than others, thus confounding the relative valuation methods in common use in the stock market. Prices of real assets such as land often outpace the rate of inflation. This is an anomaly because part of the rate of return on real estate is the non-pecuniary use-value gained from it, particularly from residences. We would expect the monetary rate of return from stocks, which is entirely monetary, to exceed that of real estate, which is only partly monetary and less risky to boot.

T-bills have been viewed as a quintessential “riskless asset” for over two centuries. That is reflected in their low “real” return – only 0.7% greater than the inflation rate. This, too, is now somewhat suspect, as U.S. federal government spending has ballooned to a size that casts doubt on the likelihood of debt repayment.

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What Does the Future Hold for Retirement Rates of Return?

Given the foregoing, a conservative retiree would do well to view the Ibbotson table with a grain of salt. Only the rate of inflation seems like a reasonable planning parameter, since governments show no diminished willingness to debase their currencies. Indeed, the enhanced presence of government in economic life makes forecasting very difficult. All in all, the auguries seem to point toward lower rates of return for stocks. The computer and digital revolutions have vastly increased productive potential, while destroying large chunks of the old economy. The business end of this revolution is dominated by search and social-networking firms with two salient characteristics: they employ few people and they pass along their productivity gains to consumers quickly and copiously. Directly and indirectly, this spells lower returns to business. The prospect of more government ownership, regulation, and control reinforces this tendency.

This picture of business pessimism extends as far as the eye can see, but history proves that is not very far. Even so, a reasonable future projection of the Ibbotson table might look something like this:

  • Small stocks: 9%
  • Large stocks: 8%
  • Real estate: 8%
  • Bonds: 4%
  • T-bills: 3%
  • Inflation: 3%

Although forecasting rates of return is chancy proposition, certain other investment relationships have proven more durable. One of the leading financial theorists of all time, Nobel Laureate William Sharpe, found that standard deviation and correlation of returns were much more stable and reliable over time than rates of return. In simplified terms, this means that the range within which returns fluctuate doesn’t fluctuate that much and neither does the degree to which different classes of returns change at the same time.

Correlation of Rates of Return and Portfolio Risk

Correlation is important because it affects the risk of the investor’s portfolio. Retirees are hypersensitive to risk because the lack of earned income puts them in danger of running out of money. The way to reduce portfolio risk is to combine assets that do not move in the same direction at the same time.

One traditional way to do this is to hold foreign stocks. That is the theory behind the international families of mutual funds, which have proven quite successful over the last two decades. As the present worldwide recession shows, however, there are times when most of the world’s stock markets decline simultaneously.

The new frontier in risk reduction is probably in the field of commodities. These are three categories of goods – agricultural (wheat, cattle, sugar, cotton, cocoa, coffee), energy (oil, gasoline), and metals (gold, silver). Prices of these goods have been shown to be uncorrelated or negatively correlated with other asset prices. Unfortunately, commodity prices tend to be quite volatile. The mechanics of trading in the spot and futures commodities markets are complicated and require experience and expertise. Commodities markets lack one thing that makes it possible for retirees to invest comfortably in volatile equity markets – representative indexes and derivative assets.

Until commodities markets develop a functional analogue to the Standard & Poor’s 500 Index, the best way for retirees to use them for risk reduction is the old-fashioned way – by buying gold and silver, either directly or indirectly through stocks or funds.


Plenty of long-run historic data exist on rates of return, compiled by solid researchers like Ibbotson Associates. Unfortunately, it is less applicable to retirement investment than to investment for retirement. The retiree lacks the advantages open to younger investors – continuous investment, accumulation of inexpensive shares during market downturns, reinvested gains, and the ability to recoup losses by investing future earnings.

Past rates of return, even when averaged over many decades, are contaminated by artificial measures introduced by government. These include pegging of interest rates, which reduces the reliability of historic bond and stock data. Inflation has distorted logical market relationships between stock and real-estate returns. The prospect of increased government involvement bodes ill for forecasting the future climate of retirement investment.

Current data and trends argue for pessimism about business rates of return. Risk reduction – as represented by the lack of correlation between returns to different assets in the portfolio – offers one way for retirees to safeguard their assets. Although commodities markets hold promise in this area, they are not sophisticated enough to handle the needs of retirement investors today. Traditional investments in gold or silver are probably the best way to reduce portfolio risk today.

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