The Personal Finance Podcast - How to Estimate Future Returns When Planning Your Retirement (Get this Right!)

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Starting point is 00:01:27 What's up, everybody, and welcome to the personal finance podcast. I'm your host, Andrew founder of mastermoney.com. And today on the personal finance podcast, we're going to be talking about how to estimate future returns when planning for retirement. And if you guys have any questions, make sure to hit us up on Instagram, TikTok, Twitter, at Master Money Co. And if you want your questions answered directly, make sure you subscribe to the Master Money newsletter. And that is where we're going to answer all of your questions directly. And you'll get a chance to have your questions answer on the show as well. Also, don't forget to follow the podcast on Spotify, Apple Podcast, or whatever podcast player, you love listening to this podcast on and leave a five-star rating and review if you're getting

Starting point is 00:02:10 value out of this podcast on your favorite podcast player. Now today, we're going to be diving into how to estimate future returns when planning for your retirement. And this is super important to get right because what we talk about here on this podcast is a lot of times when we're trying to motivate people, we use historic returns. And typically historic returns in the S&P 500 are going to be right around 10%. But what I like to do when I start to plan out my future returns and when I start to put together my retirement plan is I want to make sure that I maintain a conservative rate of return. The reason for this is I have no idea what's going to happen in the future. And you can hear people say this all the time.

Starting point is 00:02:50 Past returns are not indicative of future results. And that's absolutely true. But at the same time, we want to make sure that the only day that we have to go off of is historic returns. But what I like to do personally, and if you've ever worked with me on master money coaching or anything else like that, you know that we dial this down a little more. So I like to get closer to a lower number and get more conservative as we go through and start to plan out our retirement just to give myself extra cushion because there's power in having that additional cushion. So it's really important to make sure that we get these returns right, that we think through this in the proper way and that we have a system in place in order to put this together for our retirement plan so that we can plan this correctly. Because if you are way too aggressive with this and people like Dave Ramsey, for example, will say, well, you can get a 12% rate of return.

Starting point is 00:03:35 That, to me, is extremely aggressive in something where a lot of people will miss the mark if they go towards a 12% rate of return. And then there's some people out there who are saying, oh, I like to average out at a 6% rate of return. Well, I think that is way too conservative on the spectrum. And most people, if they get to a 6% rate of return, it's better than going to 12 because you'll hit your mark faster. But at the same time, you want to get more accurate so you can get an accurate depiction of the date that you would actually retire. So we want to make sure that we are getting closer and closer to the right number as we start to think through what rate of return we want to utilize to start planning. And so in this episode, we're going to be diving into thinking about historic returns and how we want to think through that. We're going to give you a bunch of different tools that you can use to look at your portfolio and plan out your portfolio and your asset allocation.

Starting point is 00:04:24 We're also going to take a look at some really cool charts with Vanguard. We'll have this linked up down the show notes below. But it's going to show you the average rate of return based on specific portfolio. And we're also going to consider spending phases in retirement as well because this is something I think a lot of people don't think through when they start to plan out their retirement. So we want to think through those spending phases and what we need to do. So if that's something you're into, let's get into it. So first let's talk about historical returns. And we want to talk through why somebody would even consider utilizing historical returns when they're kind of using their rate of return. And first of all, I just want people to understand. This is the only action. actual real data that we have to go off of. Sure, past performance is not indicative of future results, but at the same time, we don't have any other data. We don't have that crystal ball to kind of understand what is going to happen in the future. So we have to look at the past in order to see what's going to happen. And typically, the market moves in cycles where a lot of times recessions

Starting point is 00:05:23 happen every 10 to 12 years. And the market moves in very consistent cycles, at least historically, it has in the past. And so we can utilize this historic data. to really help us moving forward as we start to think through this process. And one big thing to note is that finance studies use historic data. When they are looking at different financial studies, that's what they are doing, because it's all we can rely on. We need some sort of starting point, some sort of anchor point that's going to allow us to get accurate data. Bill Bangin, who is the founder of the 4% rule and how actually developed the 4% rule, based his calculations off historic data of the U.S. stock and bond returns. And there are some

Starting point is 00:06:01 key points that he looked at as well. He looked at the historical data range from 1926 to 1992. In this period, the best part about this was this actually included various economic conditions, such as the Great Depression, there was multiple recessions during this period, and there were also period of very high inflation. He also looked at portfolio asset allocation. This is going to really matter when it comes to your rate of return, which we're going to talk about more here, but the types of stocks and bonds that you have in your portfolio, that's going to dictate. state what rate of return you're actually going to put in your retirement plan because you can't have a large portion of bonds in your retirement plan and think you're going to get an 8 to 10% rate

Starting point is 00:06:41 of return. You've got to go closer to what that portfolio looks like. So portfolio construction is really, really important when we want to look at these rate of returns. So we've got to think through that as we start to develop this. And we want to make sure we have an inflation adjustment. So the 4% rule absolutely did that. They adjust for inflation. And every year when you are withdrawing that 4%, you're adjusting for inflation every single year. And so that's a really important distinction to make sure that you have within your portfolio as well. Now, I'm going to give you some of the pros to historical returns and why you should consider

Starting point is 00:07:12 historical returns and then maybe adjusting those returns down to be a little more conservative going forward in the future. So first is empirical data. So historical returns provide empirical data that reflect how different asset classes have performed over various economic cycles. So what I mean by that is historic data, shows things like economic growth. What happens during times of economic growth? What happens during times of recessions? What happens when there's really high inflation or deflation going on?

Starting point is 00:07:40 We have to be able to look at that and how stocks respond to that and how the market responds to that. And typically, we really don't want to care about that kind of stuff. We know it's going to happen. Recessions are very normal. High inflation periods are very normal. This is cyclical. And we got to make sure we keep our emotions out of the equation. And instead, we look at the North Star, which is our financial freedom. That's what we are truly doing this for. And so we want to make sure that we think through that. The second pro is it helps us look at risk assessment. So by analyzing historical returns, investors can gain insights to the potential risks and volatility associated with different investments. So understanding this past performance helps us in assessing the likelihood

Starting point is 00:08:22 of outcomes in the future. That's why it's really important to make sure that we think through that. Long-term trends. So over long periods, especially really, really long periods, we are able to see a bunch of different trends and patterns that exist. And sometimes these trends can just help us with guidance from different asset classes to kind of how they perform in different economic periods. I also like to utilize it for stress testing. So a lot of times you'll hear me talk about this. I'll look at the 2007-2008 recession, the Great Recession, and I'll look, hey, what happened during that time frame? Because that's about as bad as it can get financially. And it can get, obviously, can get worse. But that is probably the worst financial event that we've had since the Great Depression.

Starting point is 00:08:59 And so we want to look at things like that and say, hey, worst case scenario, my portfolio can get cut in half in a recession. I want to understand this kind of stuff so that I can reduce my emotions when this stuff happens. It's also going to help us look and provide insights on how inflation impacts investment returns. So we are in a really high inflationary period right now. How is that impacting our investment returns going forward? Historical returns can help us look at that because you can look at different timeframes, which is powerful. I'm going to show you a tool on how you can use that in a second. And then it also shows like regulatory and market changes. So when regulations change, what happens to the market, when innovation happens,

Starting point is 00:09:38 what happens to the market. And how we understand those different factors and how the market is influence is really, really powerful in making sure that we know what's going to happen in the future. Now, I say all of those pros, and there's also some drawbacks. And some of these drawbacks are going to be something that you definitely want to consider when you were starting to build out this portfolio. Obviously, the first drawback is the one we've been talking about the entire time, which is we have no idea what's going to happen in the future. This past performance could mean nothing going forward. Maybe Bitcoin takes over the world or AI takes over the world and everything changes.

Starting point is 00:10:09 But this is something we have to deal with. And it's something that we cannot worry about whatsoever. We focus on the things that we can control, which is our income, making sure we grow our income over time, taking a portion of that income and putting it towards our investments, and then allowing that money to grow and to compound over time. That's what we can focus on. And so when you're a passive investor, if you're an index fund or ETF investor, that's what we look at. We just automate this entire process so we don't have to worry so much.

Starting point is 00:10:36 And honestly, you do not want to worry about the day-to-day market, the week-to-week market, even the month-to-month market. We want to look at long-term results. That's all we care about is long-term investors here. Now, another con that people will bring up is things like survivorship bias. And this means that, you know, historical data often includes only surviving companies and markets and potentially overlooks those that have failed. But again, if you're an index fund investor, you invest in the S&P 500,

Starting point is 00:11:01 or maybe you're an investor in something like a Target Day retirement fund, if that's how you invest, survivorship bias doesn't matter to you because companies that fail leave the S&P 500 and the ones that are performing well are added back into the S&P 500. So index funds are a great way to invest just so you don't have to worry about that kind of stuff.

Starting point is 00:11:18 There's also things like changing economic conditions, inflation variability, and interest rate environment, of those can impact the future results. And so we want to make sure that we just understand that. And those are some of the cons of using past performance. But really, to me, in my opinion, is that past performance is the only data we have as that anchor point. We need something to anchor our thought process as we move forward. And so I like to look at past performance and see what happens during that time frame. So what I'm going to do now is after this break, we're going to go into tools that are going to help us out in mapping this out over time. And we're going to

Starting point is 00:11:54 look at some historic data. But in addition, these tools are also going to help us put in our rate of return that we want to utilize that we think is conservative enough for our portfolio so that we can make sure we have the right number in there. So I'm going to go through these tools next. And then we're going to look at some cool Vanguard charts as well and see how specific portfolios have performed over time. We're going to go from the ones that I performed the worst all the way to the ones that have performed the best. We're going to do that next. All right. So there are I remember when I needed to hire someone fast, but finding the right person quickly felt impossible. And if you've ever been there, you know how stressful this can be.

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Starting point is 00:15:30 that you can utilize to start to plan out your portfolio. And I love these three tools to put together some sort of understanding of how well my portfolio is going to perform. So the first one is ficalc.com. And I learned about this actual website from Rob Berger, who is been on this show before and as a friend, we actually spent some time together. I shares invited us up to go to the New York Stock Exchange and watch the opening bell for some of their target date ETFs. And so Rob and I got to spend some time together there. And he was telling me about F.I. Calc. And F.I. Calc is a tool that I've seen on his show a lot as well. He has a YouTube channel called Rob Berger. And on his YouTube channel, he actually talks about FICALC a lot.

Starting point is 00:16:11 And that's how I found this tool. And it's an amazing tool because what this does is it actually helps you put in your retirement plan and some of the things that you want to be doing. And it'll tell you the success rate. It'll tell you the volatility. It'll tell you a bunch of different things that would happen based on different historic simulations. And so it's really, really cool. And it's actually pretty simple to use. So you put in your portfolio information, like how much you think is going to be in your portfolio. And then you put your asset allocation, meaning the percentage of stocks, the percentage of bonds, and the percentage of cash in there as well. And it's also going to ask you a couple of questions, like how,

Starting point is 00:16:45 are you going to withdraw from this portfolio? And I love this part of it because this is going to help you understand how successful different withdrawal rates would be based on the specific portfolio and the specific dollar amount that I put into this calculation. And so I think it's really, really powerful to be able to do that. You could do things like constant dollar, percentage of portfolio, the safe withdrawal rate, the dynamic safe withdrawal rate. It has a bunch of different options in here.

Starting point is 00:17:11 And so I think it's really, really cool to use this because you can just map all of this out. So first, I'm going to put in dynamic safe withdrawal rate as we talk through this. And I'll put a million dollars, 80% stocks, 15% bonds, 5% cash. And the return on investment assumption. So you can do an ROI assumption and an inflation assumption. So I'm going to put 8% ROI assumption, a 2% inflation assumption. And then the minimum annual withdrawal, meaning how much do you actually have to withdraw minimally, which is really cool that it has that option as well. And then you put it in. So for example, this portfolio that I just put in has a 97% success rate and based on 121 out of 124 retirement simulations. Pretty cool stuff there if you wanted

Starting point is 00:17:54 to go that route. And it also will go down and show you, hey, what happens if this portfolio was from 1994 to 2023? What happens if this portfolio was from 1983 to 2012? What about 1984 to 2013? You can actually change the dates and the time horizons to see how successful this portfolio would be based on different time horizons. So it's a really cool way to actually develop some sort of idea of, hey, in the worst economic conditions historically, how would this portfolio have performed? And in the best economic conditions, historically, how would this portfolio performed? You can take those worst case scenarios and you can go in there and say, well, with my retirement plan, weather the storm, or do I need to make sure that I do a little risk mitigation here?

Starting point is 00:18:40 Maybe your portfolio only has an 80% success rate during the Great Recession. Well, if that's the case, maybe you want to adjust that portfolio slightly so that you have less risk going on. So you can ensure you're in the 90 plus percent success rate because that's where we want to be is above 95 percent to make sure that we have a success rate that is going to work for us in the future that we know, hey, this retirement plan is going to work and we want to make sure that we have that in place. And so this is a really, really powerful way to set that up.

Starting point is 00:19:08 And you can change the duration from 40 years to 30 years. It's interesting because if you change the duration, the success. rate goes down, but it only goes down about a percent, which is very interesting on this specific portfolio loan. So play around with this calculator. I think it is very, very cool tool, and it's absolutely free. You just go on the website and you can use it right away. You don't even have to enter in like an account or anything. The second tool that I love to use is portfolio and portfolio visualizer. And portfolio visualizer is another tool that helps you map out your portfolio. And I think most people who have an index fund or ETF portfolio should be putting

Starting point is 00:19:40 some of their investments in portfolio visualizer. It has a free version and it has a paid version. I just utilize the free version where you can put in, you know, your stocks, bonds, or you can put in your asset allocation, say how much money you have in there. And it'll kind of show you what your portfolio has done in the past. And that's a great way to look at some historical data as well. And it gives you a bunch of different indicators. Now, if you go with the paid version, they also have some stuff that is advanced. If you're really into the nerdy, nitty-gritty, it'll show you your portfolio and what it could do and actually do some. some Monte Carlo simulations. It can do some portfolio optimization and tactical models, all that

Starting point is 00:20:14 kind of stuff. This is not sponsored or anything. I'm just kind of telling you about a tool because I use this tool. I use the free version and I actually use that all the time to run different simulations and things like that. So portfolio visualizer is another great one. And there's also Empower. And Empower used to be personal capital. It's what I utilize to track my net worth automatically, but Empower is also has something called the retirement planner. And what they do with the retirement planner is they pair it with Morningstar data and Morningstar has some of the best data out there for index funds and ETFs and they look at that data and they will see hey how is this portfolio going to perform in the future how is it performing in the past and you can actually put in all your

Starting point is 00:20:51 retirement information in there so this is another fantastic resource i highly highly recommend empower for your net worth and just to run some of these simulations we have a link down below that you can check it out and see if that one works for you as well but i have been using in power for now, wow, over a decade now. Initially, it was personal capital. I used it to track my net worth, but they have all kinds of stuff you can do in there as well. So Empower is a great tool. Check it out with the link down below. But those three are the ones that I would use. So F-I-Calc to start to map this out, use portfolio visualizer, check out some of their tools. And then the retirement planner within Power is another great tool that I think you can get a lot of value out

Starting point is 00:21:30 of. And all three are absolutely free. So there's free versions and paid versions. F-I-Calc is 100% free portfolio visualizer has a paid version and Empower has a paid version, but there's free versions as well that give you some great data. So check those three free tools out if you want to really get some advanced calculations on your rates of return. Now I want to dive into, you know, historical data based on different portfolios because your asset allocation and your portfolio that you put together is going to be very, very important to ensure that you're actually looking at the right rate of return. So I'm going to go through this chart from Vanguard. We have it linked up in the show notes below if you want to check it out.

Starting point is 00:22:05 But this is going to give you some great info on your portfolio and what the rates of returns have been historically. So we're going to go from worse to best. So let me just say something here up front. So the worst performing portfolio is 100% bonds. Even if you had a 100% bond portfolio, it is still about the same, if not better, than right now. At the time I'm recording this, high yield savings accounts are from like 4% to 5% is what the interest rates are on high yield savings accounts. and if interest rates drop, those are going to go down pretty quickly. And so when that happens, you can still look at investing your dollars, even in 100% bonds historically,

Starting point is 00:22:43 has a better rate of return than just having your money sitting in cash. You always need to invest your dollars if you ever want to retire. You need to make sure you're investing your dollars. So just want to say that up front. Everybody listening to this podcast who has listened for a long time knows how important investing is. And so we just need to make sure that we are constantly reminded of that. 80% bonds, 20% stocks, had a 6.4.4%.

Starting point is 00:23:04 rate of return. 70% bonds, 30% stocks had a 7% rate of return. 60% bonds and 40% stocks had a 7.6 rate of return. A 50-50 portfolio, meaning 50% bonds and 50% stocks had an 8.1% rate of return, which is actually pretty fascinating because that's a really much higher rate of return than I thought it would be. 40% bonds and 60% stocks had an 8.6 historic return, 30% bonds and 70% stocks. had a 9.1% rate of return, 20% bonds, and 80% stocks had a 9.5% rate of return, 10% bonds in 90% stocks, the Warren Buffet portfolio, a 9010 portfolio, had a 9.9% rate of return, and 0% bonds and 100% stock's 10.2% rate of return. This is just fascinating to me. So this chart shows you, historically, if you have more bonds in your portfolio, the higher the bond ratio, the

Starting point is 00:24:04 lower your performance is going to be going forward. So that's what the data shows, but there is still a place for bonds in my eyes. And the reason for that is to lower volatility. It's for people who have lower risk tolerance of volatility. And as you start to approach retirement age, you may want to have more bonds in your portfolio to make sure you smooth out that ride because there are going to be years when you're spending your dollars, you want to smooth out that ride so that you can have consistent spending every single year. Unless you do not care whatsoever about how much money you spend every year. One year, you're okay spending 100 grand and another year, you're okay spending 40 grand. Then that might be something where you can still have 100% stocks in retirement. But bonds offer

Starting point is 00:24:40 that volatility evening, meaning the amount that stocks go up and down, it's going to even that out so you don't have to worry about it as much in retirement. So there's always a place for bonds in my eyes just for things like that as well. And again, if you want to see this chart, it is linked up down in the show notes below. So next, I'm going to talk about what we need to do and what I do with my personal portfolio and the rate of return that I utilize. All right. So what do we need to do with our portfolio and how do we actually want to think through this? So what I personally do is I am actually very conservative with how I model out my personal

Starting point is 00:25:14 portfolio. And the way I think about this is I hope for the best, but I plan for the worst. If you want to plan this out in a simple way, I want to make this as simple as possible. So what I do is I try to land as close as possible to around 7% when I'm building out my portfolio. So what this does is it gives me enough cushion to really strong years and really weak years. If we have a really strong year, then I'm above that 7%. If we have a week year, I'm getting close enough to that 7% where it averages out right around that 7% number. Do I think that number is lower than what will happen in the future? I actually do. And so that is something where I like to

Starting point is 00:25:49 be a little bit under what I think is actually going to happen. But I don't know what's going to happen in the future. I don't have a crystal ball or an understanding of what will happen in the future. anybody tells you they know what's going to happen in the future. They are absolutely wrong and you need to write them off. Nobody knows what's going to happen in the future. And so you have to make a conservative guess as to what's going to happen. The historic data on my portfolio is about that 10.2% range at the time I'm recording this. And so when I'm looking at that data, I'm saying to myself, well, I'm going to adjust this down about 30%

Starting point is 00:26:20 because that's going to increase the probability of a successful portfolio. But I want to show you the reason why I do this, because let's map this out, for example, with a Roth IRA just to show you the difference over the course of 30 to 40 years. So if you utilize a Roth IRA and you got a 7% rate of return and you put $7,000 per year in that Roth IRA, after the course of 40 years with a 7% rate of return, you're going to have $1,397,000 in that Roth IRA. That's absolutely fantastic. Compound interest is amazing.

Starting point is 00:26:51 But let's just change the rate of return up to 10%. let's say I use the historical returns at 10%. Well, that's going to change my portfolio to $3.1 million. That's a massive difference. And if you're planning on withdrawing $120,000 per year, if you subscribe to the 4% rule and you actually put in that 10% rate of return and it doesn't happen, well, then you're stuck with a portfolio that has, at a 7% rate of return, $1.3 million.

Starting point is 00:27:21 I mean, that is a massive difference in portfolio. it can drastically adjust the amount that you want to save. So what I like to do is go lower. And the reason why I like to go lower for planning, but higher when I'm trying to motivate myself, is because lower is going to make sure that you can hit that goal faster. And that's the entire thing here. You really want to hit goals faster than you're actually trying to hit them.

Starting point is 00:27:42 And that's going to, A, increase your motivation. But B, also, you're going to be surprised how fast you could retire if you do get that 10% rate of return over the course in the next 20 to 30 years and then 40 years and beyond. So this is something that I like to do when it comes to just mapping it out. It's just going lower because you can see how drastic that difference can be if you go too high. And I just don't want anybody to go too high and then mess up their retirement plan based on that. Here's some reasons, other reasons why I do this. A, it forces me to invest more, meaning I'm going to invest more dollars because my rate of return is a little bit lower. So my plan actually tells me I need to invest more dollars. And so it's going to force me to get more dollars into that account. So if you struggle with investing more and you need to automate more money, into these investment accounts. This is a great way to do that is to map out at a lower rate of return. This also will allow you to achieve your goals faster. So the speed at which you can actually achieve those goals, you may have got done five years earlier because you map this out at a 7% rate of return instead of 10. And you reduce the risk of planning failure, meaning you want to make sure that

Starting point is 00:28:42 your plan actually works and you want to make sure that you are not going to have a failed plan. And that's what this helps you do. So listen, I hope this episode help you guys out to think through your rate of return and how you're going to plan this out in your retirement planning. We have some episodes coming up on how to plan out your retirement. So I wanted to give you this up front and kind of talk through this with you so that you can say, hey, I want to map out my rate of return. Now, if you want to go to 8%, if you're comfortable with 9%, more power to you. There's nothing wrong with that whatsoever.

Starting point is 00:29:10 I'm telling you what I do and how I think about this and why I do it in that way. So listen, I hope you guys got value out of this episode. And thank you so much for joining me today. I cannot thank you guys enough for investing in yourself by listening to this podcast today. Please, again, if you guys have any questions, feel free to reach out to me. And if you got value of this episode, please share it with a friend. I know you're going to have a powerful week over the course of the next couple of weeks. So thank you so much for listening.

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The Personal Finance Podcast - How to Estimate Future Returns When Planning Your Retirement (Get this Right!)

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