Retirement Planning in a World of Lower Investment Returns

Over the past 90 years, from 1926 through 2015, the S&P 500’s average annualized returns were just over 10%. Long-term U.S. government bonds returned 5.72%, and inflation averaged 2.93%. These returns look pretty good if you’re investing for retirement, but if you know even a little bit about investing, you know that past performance is no guarantee of future results.

Indeed, some market analysts think that today’s investors – whether retirement is on the horizon or still decades away – should figure that their returns will likely be significantly lower than in the past. If you think they might be right, how should you plan for retirement?

Saving During Your Working Years

If you believe future returns may be lower and you are still working and accumulating savings for retirement, one option is to save much more than the traditionally recommended 15% of your income. That amount could be as much as 30%, including any employer contributions, if you expect your returns after inflation to be zero, retirement expert Larry Siegel told Barron’s in a November 2015 interview. The idea, he says, is that you’re trying to make 40 years of earnings last for 70 years (40 working years plus 30 retirement years). The obvious drawback of this strategy is that saving 30% of income just isn’t possible for a lot of people. (See Retirement Planning: Why Real Rates of Return Matter Most.)

Another option is to have a more aggressive asset allocation for your portfolio. The standard recommendation has long been that when you’re in your 20s, you should allocate 80% of your portfolio to stocks and 20% to bonds. As you get older, you gradually shift more of your portfolio out of stocks and into bonds: 70% to stocks in your 30s, 60% in your 40s and so on. Instead, you could keep more of your portfolio in stocks as you get older since stocks perform better than bonds in the long run. (See Is ‘100 Minus Your Age’ Outdated?)

Some people plan to work past the traditional retirement age of 65 because they won’t have enough saved by then or because they enjoy working or both. This plan is perfectly valid, but realize that your health may not allow it. You could have to stop working before 65. (Learn more about protecting your income during your working years in Intro to Insurance: Disability Insurance.) You also may not want to work past 65. (See How Gen Y Can Avoid Working Forever.)

...And Spending Less

People can’t predict how the markets will perform or how long they’ll be able to work. What we can control is how much we spend. Choosing a frugal lifestyle is a good long-term strategy for making sure you can always meet your key expenses. Living frugally is about making lots of smart, small, habitual decisions, like:

  • making your own coffee for pennies a cup instead of paying someone else several bucks to do it for you
  • choosing a smaller home to reduce maintenance costs and energy bills
  • eating well and exercising regularly to avoid preventable, costly diseases

(For more ideas, see Budgeting Basics and 5 Money-Saving Shopping Tips.)

It’s also about making smart long-term decisions. Instead of focusing on the monthly expense of a major purchase like a car or a home, think about the long-term cost. Buy the reliable, low-maintenance car that you can pay for with cash or with a very low interest loan. Get the 15-year mortgage instead of the 30-year mortgage because – even if monthly payments are higher – you will pay dramatically less in interest over the long run.

You can also plan to earn supplemental income in retirement that doesn’t necessarily depend on your being in good health. For example, a rental property could generate income with little involvement on your part if you hire a property management company. (See our tutorial: The Complete Guide to Becoming a Landlord.)

By adopting a combination of saving and spending strategies based on what fits your situation best, you can guard against the possibility of below average long-term returns.

Withdrawal Mode for Retirement

If you think the current low interest rate environment is the new normal and you are already retired (or on the verge), you don’t want to have too much of your portfolio allocated to bonds, cash or cash equivalents. If you do, your returns won’t be high enough to sustain your portfolio.

You also might need to plan to spend your nest egg more slowly. This means using a lower withdrawal rate. Instead of starting at 4% and making annual adjustments based on inflation and market performance, you might need to start at 3%.  In a worst-case market scenario, a $1 million portfolio could still last 30 years using this method, according to an analysis by retirement income professor Wade Pfau of the American College of Financial Services. If market returns end up better than expected, you can adjust your plan and start withdrawing more as you move further into retirement. (For further reading, see What’s the Best Retirement Drawdown Strategy for You?)

Finding Other Sources of Cash

If you’re not going to withdraw as much from your portfolio each year, you’ll have to spend less, find a source of supplemental income or both. No one wants to downgrade their standard of living when they reach retirement, but if the alternative is not retiring or running out of money prematurely, you have to choose the lesser evil.

Downsizing your home, whether you own or rent, could have a sizeable effect on your finances. If you rent, downsizing means having more cash to meet expenses other than housing. You’ll probably have lower utility bills as well. If you own, selling your home and buying a less expensive place could be a great way to add cash to your portfolio that can be invested to generate income.

As for working, you might be able to parlay your life’s work into a freelance business or consulting job that’s part time and on your schedule, allowing you to still enjoy much of the scheduling freedom you hoped to have in retirement. You might even find that you prefer the structure and personal interaction that working adds to your day. (See Why to Start Your Own Business During Retirement and Starting a Small Business.)

Reverse Mortgages and Annuities

If you don’t want to sell your home but you’d like to make use of the equity you’ve built up, consider a reverse mortgage. It’s a complicated financial tool that you should educate yourself about thoroughly to make sure you understand the fees, which can be expensive, and the consequences, including not being able to leave your home to your heirs. But for some retirees, a reverse mortgage can be a good choice. (See 5 Signs a Reverse Mortgage Is a Good Idea and How to Choose a Reverse Mortgage Payment Plan.)

Buying an annuity is another option. Some advisors recommend using a small percentage of your nest egg to purchase an annuity that will act as longevity insurance. In the previously mentioned Barron’s interview, Siegel recommended a deferred annuity, also called a qualified longevity annuity contract, purchased with 15% of your assets to cover your cost of living after age 85. You could pay $100,000 at age 65 for an annuity contract that would pay about $40,000 a year starting at age 85, he says. 

The risk is that you may not reach age 85, in which case you will have lost the opportunity to use the money you spent on the annuity during your lifetime or to leave it to your heirs. Certified financial planner Michael Kitces writes on his blog that “longevity annuities can be a compelling fixed income alternative for retirees,” but adds that “relative to an equity portfolio, the longevity annuity is arguably still inferior, at least given today’s payout rates.”

The Bottom Line

Even looking at the past 20 years, which include both the dot-com bust and the Great Recession, annualized stock returns are about 10%. Still, if you want to plan for lower returns, you now have some options to consider implementing. (For more insights, read Why Your Retirement Portfolio Can’t Rely on High Rates of Return.)