Keep reality in mind when planning investment returns

What have investors learned from the stock-market losses of the new century?

Not enough, apparently.

A new study by John Hancock Financial Services shows that investors are clinging to some out-of-date, '90s-style expectations that could leave many short of the money they need in retirement.

According to Hancock's survey of 801 retirement-plan investors, the average participant expects stocks to furnish annual returns of nearly 16 percent over the next 20 years. In fact, the long-term average, represented by the Standard & Poor's 500, is just shy of 11 percent.

So investors are off by a few percentage points. What's it matter?


Let's assume you can save $5,000 this year in a tax-deferred account such as a 401(k). Assume you will raise your annual savings by 3 percent a year to keep up with inflation. If your investments return 16 percent a year, after 20 years you will have a nest egg of nearly $680,000.

Cut the return to the historical average of 11 percent and you'll have just $391,000.

And what if the return over the next 20 years falls below the historical average to, say 7 percent? Then you'll have only $258,000.

Excessive optimism isn't limited to stocks. Hancock found that investors expect bond returns to average 10.31 percent a year for the next two decades. That's nearly double the historical average of 5.77 percent.

Money-market delusions

Even more amazingly, investors expect money-market funds, one of the safest, most conservative places to stash cash, to pay annual interest of 9.8 percent. The historical average is 3.8 percent, and even that is hard to get these days.

No one knows what the financial markets will do over the next two decades, of course. But this is certain: If you assume you'll get stunning returns, then any surprise is likely to be a disappointment. If you plan for modest gains, a surprise will be happy news.

Hancock concluded that most of the investors it polled would fail to build the wealth needed to furnish an adequate retirement income, which it defined as 75 percent of one's pre-retirement earnings.

Are you worried yet? Maybe you should be, but maybe not. The first step is to estimate just how much money you really will need in retirement, then to devise an investment plan that has a reasonable chance of success.

That 75-percent figure is a rule of thumb that obviously doesn't apply to everyone. To get a better figure, tally your cost of living now. Add things you hope to do in retirement, such as travel, and subtract expenses you won't have. Maybe you'll have paid off your house by then.

Next, figure the retirement income you expect from dependable sources such as a pension and Social Security. Subtract that from your living-expense figure and you've got the gap that will have to be made up by income from investments.

Now you have to search for various ways to get there. This really requires a computer loaded with financial software, such as Quicken or Microsoft Money.

Suppose you want to receive $30,000 a year in income, after taxes, from your investments, starting when you retire in 20 years.

You could get that by investing about $4,000 this year, then increasing the amount 3 percent every year for inflation. If you got that stellar 16 percent return, you'd have about $553,000 when you retire. That would give you about $64,000 in annual income — the amount you'd need to cover taxes and make up for 20 years of inflation and still buy what $30,000 buys today. And it means all your money would be spent by the time you turn 95. Of course, you're not likely to get 16 percent.

By assuming a more likely return of 7 percent, you'll need to save $22,500 this year. Again, that will have to grow each year to make up for inflation.

Tinker with assumptions

If that's just too much, don't give up — tinker with the assumptions. Suppose you retire in 22 years instead of 20. And suppose you expect to live to 90, not 95. In this case, you can reach your goal by saving $16,800 a year.

Still too much? Well, we assumed you were starting from scratch. If you already have $50,000 in investments, you need to start the process with $13,300 a year.

And if that's too high, maybe you should change your spending plans. If you needed $25,000 a year instead of $30,000, you could start by saving $10,500.

Playing these "what if" scenarios is a great way to peer into the future. But remember the old saying about computers: "Garbage in, garbage out." Play it safe and assume modest returns. The days of 16 percent annual gains in stocks are probably over. These days, most of the play-it-safe experts say it's smarter to assume 6 percent or 7 percent.