The Average Return Fallacy

It’s likely the most common error in every retirement plan in existence: the average return fallacy.  You just assume a straight line rate of return of 5% for your entire life.  Of course things don’t work that way in real life, often you get 5%, 2%, 9%, -10%, etc,  so the numbers never match your plan.  Yet since we can’t model future markets we are stuck with this problem. Now that provides two distinct challenges: one is saving for retirement and the other is while in retirement.

The first challenge of saving for retirement is more manageable in terms of impact.  If your assume 5% for a straight line return and you end up being a little short at your desired date you can obviously just keep working for an extra year or two to make up the difference.  Or the other way is you might find yourself at your goal a year early.  Essentially you let the dollars determine when your done rather than your desired date.  It means letting go of your perceived control of the situation, but otherwise it’s a manageable issue.

While in retirement, the situation is much more serious.  Your portfolio could never recover from a string of bad years in a bear market since you have no new cash coming in to make up the loses from the down years. Also hiding in bonds won’t cut it since you could see your spending power cut down too far by inflation over the long term.  So what can you do?  Well here are a few ideas on managing the risk.

  1. Save Some Extra.  Padding your numbers for a bit is not a bad idea to help reduce the risk.  One example is a three year spending cushion of cash beyond your basic capital requirement in a separate fund for the express purpose of being able to limit withdraws during a down market.   Some other people just add 10% to their spending to cover off some risk.  It’s really up to you how to pad your numbers.
  2. Do Some Work.  Even if you don’t need the money for a very long retirement you might consider keeping some part time or contract work.  This has two fold reasons, you will increase your CPP payout when you qualify and second it offsets some cash withdrawals from your portfolio during your early years giving it a better chance to survive a down market later on.
  3. Be Willing to Sell Other Assets.  If you have a vacation property you can sell or be willing to downsize your home it might be able to top up your portfolio if it gets too much of a drain early on from your withdrawals.  This has the risk of the local real estate market might fall on you so don’t depend on this one too much.
  4. Reduce Your Spending.  Having a little fat in the budget is a good thing to allow you to cut back later on, but keep in mind depending on how bad the damage is to your portfolio you may be cutting back your spending permanently.
  5. Buy Some Insurance.  An annuity might seem a bit odd of an idea, but it does transfer the risk to the insurance company from you.  As part of an overall plan this might make sense to buy a few smaller ones to stabilize a portion of your income.

In my own case I’m considering using all of the above to some degree.

  • I’m considering moving my three year case reserve from inside the portfolio in the current plan to outside of it.  Yes I might have to work an extra year or two, but so be it.
  • I’ve also planned on doing some work post retirement, so that also provides some backup.  I’ve never planned how much, I intend to play that by ear.
  • I’m planning on downsizing my house at some point to reduce my bills (mainly property tax and heating) and because I won’t need the space once the kids are gone.
  • I’m willing to give up my vacation fund if need be.
  • I haven’t ruled out a smaller annuity to help manage my overall risk during my retirement years.  It’s not my first choice, but I’m willing to consider it.

So that’s my take on the problem.  It is a problem, but one you can cover off to a degree with a few backup plans.  Obviously I won’t know if I will have done enough until after I die with some money in the bank and then it’s not my problem.  So yes you need to manage the risk, but don’t let the gloom and doom talk keep you working longer than you need.  Some balance is required.

4 thoughts on “The Average Return Fallacy”

  1. I think you make some good points in your post. My question is, is luck the only way to plan? You said you might be above or below the 5% and then how to adjust if you are below. Is there a better way to plan? A way to make sure you are above the 5% rather than just runing projections that can never happen (i.e. 5% straight line return)?

  2. EoW,

    You have a few options on how to handle it. You can save less than you can to hold some in reserve in case you don’t need it. Or pick a lower return average than you expect to get. If you expect 6% perhaps choose 4% that way you should be exceeding your goals most of the time.

    Beyond that there isn’t a lot of adjustments you can do. Save and wait for the right time when it comes.


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