Retirement Planning: Why Real Rates of Return Matter Most
When evaluating your portfolio’s performance, what number do you look at? Your brokerage firm might tell you that your portfolio returned 10% last year. But thanks to inflation, the increase in the prices of goods and services that typically occurs month after month, year after year, a 10% return – your nominal rate of return – isn’t really a 10% return.
If the inflation rate is 3%, your real rate of return is 7%. That’s the actual percentage by which your portfolio’s purchasing power has increased, and it’s the percentage you need to pay close attention to if you want to make sure your portfolio is growing rapidly enough to enable you to retire on schedule. Once you’ve retired, your real rate of return remains key: It affects how long your portfolio will last and what drawdown strategy you should follow.
“An investor is better off getting a 6% return in a 2% inflationary environment than getting a 10% return in a 7% or 8% inflationary environment,” said Certified Financial Planner Kevin Gahagan, principal and chief investment officer with Mosaic Financial Partners in San Francisco. High returns are appealing, but returns after inflation are what matter. What's the Best Retirement Drawdown Strategy for You? gives further details.
If you understand how inflation affects you – and how different asset classes react to inflation – you can develop an investment strategy that is more likely to give you the real rate of return you need.
Your Personal Inflation Rate
The consumer price index (CPI) tells us how much the price a basket of consumer goods has increased over a given time.
While the CPI is the most widely used measure of inflation, what really matters is your personal inflation rate, Gahagan says. Depending on what you buy, the inflation rate defined by the CPI might not apply to you. It’s key to have a thorough and detailed understanding of where your money goes to understand how your situation is affected by inflation, he says.
Suppose your expenses are $40,000 a year at age 65. By the time you’re 90, you’ll need $80,000 a year to buy the exact same things, assuming 3% annual inflation.
If CPI inflation is 3% per year but you’re spending a ton of money on healthcare, where prices are rising at about 5.5% per year long term, you need to factor that into your portfolio investment and withdrawal strategies. (Learn more in our tutorial, All About Inflation.)
How Inflation Affects Different Asset Classes
Investment rates of return will generally adapt to reflect the level of inflation, Gahagan says. Specifically, equity investments, real estate and stocks are better able to respond to a rising inflationary environment as opposed to fixed income investments, he says. In a highly inflationary environment it is not uncommon for fixed income to fall behind.
Let’s take a closer look at inflation’s typical effect on each asset major class. (To learn more about inflation, read Coping With Inflation Risk.)
Initially, higher-than-expected inflation can have a negative impact on corporate profits and stock prices since production inputs are increasing in price. But overall, stocks can help you hedge against inflation since corporate profits tend to increase along with inflation once companies adjust to inflation rates.
Inflation has different effects on different types of stocks, however. Higher inflation tends to hurt growth stocks more than value stocks. Similarly, dividend stocks can suffer when inflation is rising since the value of the dividends might not keep pace with the rate of inflation. That’s good if you want to buy dividend stocks, but bad if you want to sell them or if you’re relying on dividend income. Value stocks tend to perform better than dividend stocks when inflation is high. So it’s important to not just have stocks in your portfolio, but to have different types of stocks. (Learn more in Inflation’s Impact on Stock Returns.)
Treasury Inflation-Protected Securities (TIPS) do just what their name suggests: Their par value increases as the Consumer Price Index increases. Their interest rate stays the same, but since you’re earning interest on more principal, thanks to the higher par value, your investment doesn’t lose ground to inflation. (See Introduction to Treasury Inflation-Protected SecuritiesIntroduction to Inflation-Protected Securities.)
In a stable environment with 2.5% to 3.0% annual inflation, Gahagan says, 30-day T-bills will typically pay the same rate as inflation. This means T-bills let you offset inflation, but they don’t offer any return.
While returns that are guaranteed to keep up with inflation combined with the safety of the US government’s high credit rating may be appealing, you don’t want to have too conservative a portfolio, especially early in retirement when your investment horizon might be 30 years or longer. You might decrease your allocation to stocks as you age, but you should still have some percentage of your portfolio in stocks to protect your portfolio against ongoing inflation.
What about other government bonds that aren’t guaranteed to keep pace with inflation? When you invest in a bond, you’re investing in a stream of future cash flows. The higher the inflation rate, the faster the value of those future cash flows erodes, making your bond less valuable. But bond yields reflect investors’ expectations about inflation: If inflation is expected to be high, bonds will pay a higher rate of interest, and if investors expect inflation to be low, bonds will pay a lower rate of interest. The bond term you choose affects how much inflation will hurt the value of your bond holdings. (Read more in Understanding Interest Rates, Inflation and Bonds.)
A portfolio with short-term bonds looks good in an inflationary environment, Gahagan says. It lets you adapt quickly to changes in inflation and interest rates and not experience decreases in bond price value. In a flat and low interest-rate environment, short-term investments cost you money. But in every rising interest rate environment, from the low point to the high point of the interest rate cycle, short-term bonds had a positive return, Gahagan says.
Another way to protect your portfolio against inflation is to include emerging market funds in your portfolio, since their performance tends to differ from that of developed market funds. Diversifying your portfolio with gold and real estate, whose values tend to rise along with inflation, can help, too.
Adjusting Your Portfolio for Inflation
Since inflation affects different asset classes in different ways, diversifying your portfolio can help ensure that your real returns remain positive, on average, over the years. But should you adjust your portfolio’s asset allocation when inflation changes?
Gahagan says no, because people are likely to make tactical errors based on the news of the day and the fears of the day. Instead, investors should develop a sound, long-term strategy. Even in retirement, we usually aren’t investing for the short term. For example, at age 65, we’re investing for the next 25 to 35 years or longer. In the short term, any number of unfavorable things can happen, but over the long term, these things can balance out, he says.
The same guideline that applies during your working years – choose an asset allocation that’s appropriate for your goals, time horizon and risk tolerance, and don’t try to time the market – applies during your retirement years. But you do want to have a diversified portfolio so that inflation doesn’t have an outsize effect on your portfolio during a particular period.
Positive real rates of return are essential to not outliving your savings. If too much of your savings is in cash and cash equivalents, like CDs and money market funds, your portfolio’s value will shrink because these investments pay interest at a lower rate than the inflation rate. Cash always earns a negative real return when there’s inflation – and deflation is historically rare in the United States. But cash does have an important place in your portfolio.
A liquid reserve – something over and above your normal outflow – is a good idea for retirees, Gahagan says. In the event of a market downturn, your liquid reserve lets you shut off the tap from the portfolio and draw on cash instead. By avoiding taking money out of your portfolio when the markets are falling, your portfolio will recover better.
Gahagan says most of his clients are comfortable with 18 to 24 months’ worth of cash reserves, sometimes 30 months. It depends on their personal comfort level, what other resources they have to draw on (like Social Security and pension income), and whether they can cut back on spending. But even after a dramatic recession like the one we saw from August 2007 through March 2009, he says his clients’ portfolios had largely recovered by mid 2010.
Thus, two years’ worth of cash reserves may get you through even a severe downturn, but it’s not such a large amount in cash that inflation will dramatically erode your purchasing power. Losses from inflation may be less than losses from selling stocks or bonds in a down market.
What Real Rate of Return Should You Expect?
Over the last 90 years, from 1926 through 2015, the S&P 500 delivered an average annualized return of just over 10%. Long-term US government bonds returned 5.72%. Inflation averaged 2.93%. That means you might expect to receive a 7% real return on stocks and a 3% real return on government bonds over the long run.
Averages are only part of the story, though, because past performance is no guarantee of future performance, and what’s actually happening with investment returns and inflation during the decades when you’re saving and investing and in any given year when you want to withdraw money from your portfolio are what matter most for you. Stocks might perform the best against inflation over the long run, but there will be years when stocks are down and you don’t want to sell them. You’ll need to have other assets you can sell – like bonds, which tend to be up when stocks are down – or another source of income or a cash reserve to rely on in years when stocks aren’t doing well. (Learn more in Your Retirement vs. Inflation.)
The Bottom Line
There’s no guarantee that even the best-designed portfolio will yield the real returns you seek. We base our investment strategies on a combination of what has worked in the past and what we expect to happen in the future, but the past doesn’t always repeat itself and we can’t predict the future.
Still, the best available information we have says that to maximize your real returns and make sure inflation doesn’t decimate your portfolio, you need to have a large allocation to a wide variety of stocks, a smaller allocation to long-term government bonds and TIPs, and 18 to 30 months’ worth of cash reserves. For precise asset allocations, it may be helpful to consult a financial planner who can analyze your unique circumstances. (For related reading, see 10 Signs You Are Not OK to Retire.)