Don't Overestimate Growth in Retirement Savings Plans


One common reason that people invest in the stock market is to build savings for retirement.

web-axstj-growthdsc_97-stj3-1013-2486.jpgMost investors have a general understanding that the stock market has delivered significantly better long-term performance than savings accounts, CDs and bond markets.

Unfortunately, many people overestimate the potential for the stock market to grow their savings. This may be one of the reasons that experts warn that most Americans are not saving enough to support their lifestyle in retirement.

Consider, for example, a 50-year-old man who has accumulated $300,000 and calculates that he needs $1 million by the time he is 60 to retire in comfort.

If he assumes that the stock market is going to return 12 percent per year, he will conclude that he only needs to save roughly $2,000 per year through his 50s, because at 12 percent annual growth his investments will double about every six years or so.

On the other hand, if he assumes the stock market is going to generate only 6 percent annual average growth over the next decade, he will assess that he needs to save more than $28,000 per year through his 50s, because at 6 percent growth his investments will double only once in a little over 12 years.

So what rate of return should people project for their stock investments?

Nobody knows for sure how fast the stock market will grow in the future. We do know that over the long term, the stock market historically has averaged approximately 10-11 percent annual growth rate per year.

Many people expect a lot more. As recently as fall 2002, more than 20 percent of investors surveyed anticipated annual average rate of return more than 15 percent — more than the stock market has ever returned over a long-term period.

Unfortunately, knowledge of historic rates of return can be misleading. Even people who are familiar with the stock market’s historic rates of return often alarmingly overestimate their actual future returns.

One reason investors often expect higher return on investment than they should is that they fail to take the cost of investment advice into account.

In addition to brokerage fees, the average annual mutual fund costs about 1.4 percent per year. Similarly, most money managers charge at least 1 percent of the first several million assets under management.

These costs easily can reduce the return of a portfolio by a percentage point or more each year. Assuming the average historic growth rate of 10 percent, that means that investment management fees can reduce investors’ return by more than 10 percent per year.

Though research suggests that professional money managers secure better returns than most individual investors, even professionals have not consistently outperformed the market on average. Accordingly, investors saving for retirement need to take into account the impact of fees on their long-term rate of return.

Taxes are an additional drag on the long-term performance of investments in the stock market that people need to consider when projecting their retirement savings.

Investments that are held outside of “qualified” retirement accounts, such as IRAs and 401(k)s, often will pay more than 20 percent of their growth back to the federal government as they realize capital gains and collect dividends.

In IRAs, 401(k)s and other retirement plans, investors will grow tax deferred, but distributions will be reduced by “ordinary” income tax rates that can reduce the value of distributions by 30-40 percent.

In addition, investors need to consider the impact of inflation, which has substantially reduced the “real” growth of investment portfolios over the years.

Jeremy Seigel, a well-known University of Pennsylvania professor who has analyzed the market’s history as much as any person, has documented how inflation has reduced the “real” rate of long-term average returns in the stock market to about 6-8 percent per year, not taking into account taxes and fees.

In my opinion, the impact of fees, taxes and inflation on stock market returns does not weaken the case for investing in the stock market, which has historically provided superior performance to other investment options even taking these factors into account.

However, it is important to recognize how these factors impact how fast our retirement savings will grow.

Nowadays, many retirement planners project only 6-8 percent annual growth when sketching retirement scenarios. Investors who count on a higher rate of return to fund their retirement accounts may need to think about increasing their contributions if they want a high probability that they will achieve their goals.