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What rate of return will your investments earn in the future – 4%, 8%, 12%?

June 29, 2012 by Editor, InvestingForMe

It’s a simple question, but your answer makes a huge difference in terms of hard cold cash for your financial future, and your investing success (or failure!) all depends on the number you pick. (Just try designing a financial plan or a retirement plan without an estimate of your future investment returns. It can’t be done!)

The right number for the right times

Let’s take a look at the number you (or your advisor) are currently using. Are you still investing like it’s 1999 and expecting to get 12%? Or are you like a deer in the headlights where you just want your savings to stay safe and you’re happy to earn 0%? (Hello!  That’s not much of a plan!)

Getting the number right

As an advisor, establishing realistic expectations for my clients’ savings and for my professional performance was one of the most important aspects of planning. Without a realistic number, my clients’ financial plans would be useless and their satisfaction with me would be short lived. Over and over the choices were made clear:

  • Set your expectations too high (say 12%) and you will be disappointed as your plan becomes irrelevant.
  • Set them too low (say 2%) and you may find your plan has you working until you’re 80.

The hardest part about picking the right number is that no one has a crystal ball. No one knows which investments will perform best over the next 5, 10 or 20 years – whether it’ll it be stocks, bonds, cash, real estate or some combination of those.

So, what to do in a world with no crystal ball

Even though no one knows the future, you still need to make plans. So, where do you start?

One of the places I always look for a reasonable estimate of future investment returns is the report card (actuarial report) written up for large pension plans. Why? For a few good reasons:

  • Pension plan investments are managed by highly skilled, educated and experienced teams of professionals. (In the investment world these investment pros are often called the Smart Money.)
  • Pension investments are managed with a long-term perspective and it is accepted the plan’s investments will go through numerous bull-bear stock market cycles, boom-bust economic cycles, and social/political cycles.
  • Pension investments are managed with an understanding that the investments must support the plan’s future financial obligations to its pensioners.
  • Pension plan administrators must maintain realistic expectations for the investment returns generated if the plan is going to succeed in the long run.

So, although no one knows the future, given all of the potential sources for selecting the right rate-of-return number, pension plans are at the top of my list.

Exhibit A

Let’s look at a recent example in the case of the actuarial report completed by the Office of the Superintendent of Financial Institutions Canada for the Pension Plan For The Public Service of Canada (one of Canada’s largest pension plans), published in May of 2012. 

In their report, the Office of the Chief Actuary outlined the pension plan’s investment expectations (i.e. rate of return) for the next 5 years as follows:

  • Long-term bonds will have an average annual real yield of 2.70%
  • Stocks will have a real return of 4.1%, and
  • Real estate and infrastructure will generate a real return of 3.1%

Note: The stated real yield and real returns are after deducting for inflation.

Translation: number break down

Also, from their report, we see the expected average annual real return for the pension plan’s investments, as a whole, is estimated to be 3.64%, for the next 5 years.

This 3.64% expected return is based upon the pension plan’s asset allocation, which at present includes:

  • 66% invested in Stocks
  • 21% in Fixed Income
  • 13% in Real Estate and Infrastructure

So, if these numbers are good enough for the Smart Money, with all of their skill, education and experience, they should be good enough for us.

Note: If your investment portfolio uses a different asset allocation, then your expected real return should be higher or lower than the 3.64% - above 0%, but below 4.1%.

What does it mean for us?

Given the current rocky state of financial affairs, the guys that wrote this report are being realistic and are not shooting high. And if we want to avoid financial disappointment, we’d be wise to follow their lead, which means this:

  • If the success of your current financial plan is dependent upon numbers like 12% or even 8% rates of return, you might want to revisit your plan.
  • If you’re invested 100% in the stock market, you might want to go back to your financial plan and plug in the 4.1% they use and see what you get.

Remember: It’s way better to pick realistic numbers today than face the disappointing numbers in the future. In a world with no crystal balls, your best bet is to follow the lead of the Smart Money.

 

(Published by RateSupermarket.ca)

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