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Making Your Investments Work For You: Things To Consider


We must remove inflation so the numbers allow for a better understanding of purchasing power growth. Real returns will be less because they preserve the purchasing power of wealth over time. Providing the discussion in terms of real returns allows us to plan for the assumption that future spending will grow with inflation. Even low inflation can compound over time into a big impact on purchasing power. Not removing inflation from the calculations can lead to confusion about the purchasing power of future dollars. The real compounded returns fell to 6.9 percent for stocks and 2.1 percent for bonds.

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When it comes to inflation, it is important to be consistent about assumptions. If spending is projected to increase with inflation in retirement, then it makes sense to discuss assumptions in real terms. Real returns are lower, but they account for inflation and support a spending need that grows with inflation. Meanwhile, if spending needs are not anticipated to grow with inflation, then discussing the return assumptions in nominal terms is fine. Nominal returns are higher, supporting higher initial spending. That higher initial spending then stays fixed instead of growing with inflation. This means that purchasing power will decline over time, but it can be an appropriate assumption if it matches the actual behavior of retirement spending.

Asset Allocation

The next step is to consider asset allocation. Though many articles about long-term investing will assume 8 or 12 percent returns, this implicitly suggests that the investor holds 100 percent stocks. That will rarely be the case, especially for retirees. Consider, instead, a retiree with a 50/50 portfolio rebalanced annually. For the historical data, Exhibit 1.1 (Return Characteristics by Asset Allocation as Based on US Financial Market Nominal Annual Returns, 1926–2018) shows that the arithmetic real return was 5.6 percent, and the standard deviation for returns was 10.6 percent. The compounded real return was 5 percent for a 50/50 portfolio.

Exhibit 1.1 provides more details about these adjustments for other asset allocations as well. These numbers make clear about how as the asset allocation shifts from stocks to bonds, the portfolio returns and standard deviations both decrease. Because these numbers also account for correlations between assets, we do also see that the lowest standard deviation occurs with 10 percent stocks instead of 0 percent stocks, despite stocks being more volatile. This is an example about how diversification can reduce portfolio volatility by including different asset classes that do not move entirely in tandem. As retirees often seek to reduce their stock allocation in retirement, it becomes important to base return assumptions on a more bond-heavy portfolio that will have a lower expected return than a high-stock portfolio.

Adjustments for Fees and Performance Relative to Underlying Indices

For some, the 5 percent real return for the 50/50 asset allocation choice might be a properly adjusted starting point for a portfolio return assumption to project retirement outcomes, if this matched the retiree’s desired asset allocation. We are getting closer. However, there are further adjustments we could make to this 5 percent number to create a more realistic and useful number for planning purposes. The number could potentially be a bit larger with a more diversified portfolio including international assets, alternative investments, real estate and small-cap stocks. This diversification would primarily serve to reduce portfolio volatility, which can provide a lift for the compounded return. Though it would entail risk, one might also wish to assign a premium to the return assumption to account for a belief that the investment manager can beat the returns on the underlying indices.

On the other hand, the 5 percent return may need to be reduced further to account for any fee drag associated with the management of the underlying investments. The index returns do not account for real-world investment expenses. It is possible to find index funds with low expense ratios, but the expenses for some actively managed funds can exceed 1 percent or even 1.5 percent per year. These are the operating expenses for mutual funds. As well, there can be an additional 12b-1 fee on some mutual funds to help cover marketing and distribution costs for the investment company. These expenses are listed separately from the operating expense ratio and must not be forgotten.

Some mutual funds will also charge a front-end or back-end load as a percentage of the assets when mutual funds are bought or sold. Beyond these explicit expenses, mutual funds may underperform market indices on account of the transaction costs for trading inside the fund and for tax inefficiencies created by fund turnover. In a 2014 article for the Financial Analysts Journal, John Bogle estimated that the all-in expenses for actively managed mutual funds could add up to as much as 2.27 percent before adding the tax impact. He estimated the tax impact as an additional 0.75 percent reduction in annual returns.

When these fees are present, they reduce the net returns, approximately, on a one-to-one basis. For instance, if a portfolio was projected to have a 5 percent return before expenses, and investment expenses add up to 2 percent, the investor could expect a net return of about 3 percent. The precise impact is even a bit larger because the expenses apply not just to the principal but also to the growth of the investment.

Adjustments for Taxes

Another issue besetting retirees is that returns will also be affected by tax drag, as ongoing taxes for interest, dividends, and realized capital gains must be paid with the passage of time. The tax efficiency for various types of funds varies, and actively managed funds generally have less tax efficiency than index funds. Morningstar has estimated that taxes for a large-capitalization portfolio like the S&P 500 can reduce annual returns by 0.68 percent. As for bonds, taxes must be paid on the ongoing interest earned by the funds, which could easily reduce returns net of tax by 1 percent or more.

In the John Bogle article just discussed, he estimated the additional tax impact of actively managed funds as reducing returns by 0.75 percent. Indeed, returns net of taxes will be less for households using taxable investment accounts. This aspect must also not be ignored when projecting investment returns for a retirement portfolio.

This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon.

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