How much can you pile up in your retirement account, if you start contributing when you're young? I have a formula that will give you a pretty good idea of likely returns over a long period. The answer: Compound growth delivers nice results, but maybe not as nice as you were counting on.
Here's the formula for the expected annual return, in percentage points, from a collection of stocks and bonds:
r = 5*S + 2*B – E
The return r is a real return, which is to say, the return net of inflation. S is the fraction of your portfolio in stocks, B the fraction in bonds, E the expenses taken off the top.
Example: You invest in a typical 60/40 mix of stocks and bonds, and the funds you are invested in have an average expense ratio of 0.8%. Then you can look forward to a 3% compound return, over a long period: 3 = 5*0.6 + 2*0.4 – 0.8.
Perhaps you were thinking of something a little richer than that? More like 7%? The promoters of retirement saving like to provide wondrous illustrations of the power of compound interest. Put away a buck when you're 27, let it sit for four decades, and a 7% return will turn it into $15. With compounding like that, you could amass upwards of $1 million for retirement from just four years of maximum 401(k) contributions at $17,500 per year.
Numbers like those are misleading, even if offered in the good cause of motivating workers to save. There are three things wrong with a 7% return assumption.
The first is that not many people can afford to take the risk of an all-stock, all-the-time portfolio. Stocks are likely to beat bonds over any long period, but it is not certain that they will. Stocks could have a 40-year bad patch. Japan is in the middle of one of those; its stocks are off sharply from their 1989 highs, and a young Japanese saver who ventured into the market 24 years ago will be lucky to have broken even over the period 1989-2029.
The second source of disillusionment for someone expecting 7% is inflation. If you retire in 2053, you will be buying things at 2053 prices with your savings. I think 2% is a reasonable forecast for inflation. Prices have gone up a bit less than that in the past year but surely the day will come when we pay for the Federal Reserve's money printing habits.
Subtract 2% from a nominal 7% total return (dividends plus appreciation) on stocks and you get the 5% real return used in the formula for stocks.
Bonds are in the formula with an expected 2% real return. Can you get that from fixed income? Maybe, provided that you include riskier bonds in the mix. If you stick to safe Treasury bonds you'll get less: The 20-year TIPS (inflation-adjusted security) has a real yield to maturity of 1%. High-grade corporates yield close to 4% these days in nominal terms and might net you close to 2% after inflation. Junk bonds and convertible bonds, at the risky end of fixed income, could give you a 3% real return.
Item three on the bad news agenda is fees. An annual cost of 0.8% is par for the course in retirement plans. If you work for a small company that doesn't pay attention to costs you might lose twice that to fees. A big 401(k) plan run by frugal managers might have average expenses around 0.3%.
You can do still better than that, if you have a plan with a brokerage window. Use it to buy cheap ETFs. For U.S. stocks, broad-market funds from Vanguard and Schwab (tickers: VTI and SCHB) are bargains. For foreign stocks, these same vendors offer VEA and SCHF. In fixed income, the iShares and Vanguard products are cheap (AGG and BND). Usually, it doesn't make sense to do a trade unless you're moving at least $20,000, so use other options, like no-load mutual funds, while smaller sums accumulate.
What about cash? Historically it has had a real return of zero, meaning that the yield on Treasury bills just about ties the inflation rate. At the moment cash has a negative real return. My formula assumes, charitably, that it will claw its way back up to zero fairly soon. Over the long term your cash position will do you little harm and little good. You shouldn't have any of your retirement account sitting idle.
Consider a hypothetical saver named Sally, with a 401(k) invested 50% in stocks, 30% in bonds and 20% in cash. The cash can be ignored. The other two components together yield her an expected real return of 5*0.5 plus 2*0.3 percentage points. That's before expenses. If Sally is coughing up 0.5% of invested assets per year to the fund managers—which comes out to 0.4% of her total account assets—then she can look forward to a 2.7% annual growth.
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Over 40 years, her $17,500 of postponed consumption will not quite triple in spending power to the equivalent of $50,800 of today's money. That's good, but nothing like the 15-fold gain she might be dreaming of if she looked at some projection using a 7% return.
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