The rate your pension fund returns over its lifetime will profoundly affect your chances of achieving your retirement goals. A couple of percentage points difference in annual growth may seem like small beans, but over time it makes all the difference.
This is starkly illustrated by using a retirement calculator and an illustrative plan:
Growth rate 9% per year over 35 years.
Projected retirement income = £27,000 p.a.
Growth rate 7% per year over 35 years.
Projected retirement income = £14,000 p.a.
Growth rate 5% per year over 35 years.
Projected retirement income = £7,000 p.a.
As you can see, the gulf in outcomes is enormous.
The worst mistake you can make therefore, when planning your retirement, is to expect an unrealistic rate of return.
What’s a realistic pension fund return?
Sadly, short of being mates with Dr Who, there is no way of knowing in advance what your rate of return will be.
We can speculate about a vast range of outcomes when envisaging the future, from the destruction of global capitalism to a stagnant developed world to the invention of nuclear fusion heralding a golden age of growth. All would affect your investments in different and unforeseen ways.
A more practical way forward is to look at long-term historical returns as the best gauge we have of market conditions through both thick and thin.
This approach doesn’t tell us what will happen – it offers us no guarantees whatsoever – but it does help us prioritise our planning.
For example, I don’t buy anti-terrorism insurance for my house. There is no history of terrorism in my area. That doesn’t mean it can’t happen. It means that terrorism is not a danger worth planning for, and I’m better off putting my money to work on more likely threats.
It’s worth knowing that:
- The average rate of return for UK equities is historically around 5%, after inflation.
- That’s a growth rate of around 8% before you strip out average inflation of near-enough 3%.
- Few investors can live with the volatility of a 100% equity portfolio, especially as they get older.
- A more typical 60:40 equities and bonds portfolio has historically achieved 4% after inflation.
- That’s why the expected growth rate of 7% (4% real return + 3% inflation) used by most retirement calculators is a reasonable base point.
- Many commentators forecast that future returns will be lower than in the past. This FSA-commissioned report sets out the case for lower returns, particularly if you have a high government bond allocation.
- The higher the rate of return you plump for, the greater the risk that the markets will fail to deliver the growth juice you need. Err on the side of caution.
- Whatever expected rate of return you choose, the reality will probably prove quite different. Prepare to adapt over time by adjusting your plan’s key components.
Asset allocation and likely returns
You can influence your expected growth rate by changing your asset allocation.
Devoting a higher percentage of your portfolio to a diversified range of equities will increase your prospects for higher growth. You can add further fertilizer by tilting your portfolio to small-cap and value equities.
These moves increase risk. The less risk you can tolerate, the more you need to dampen down your portfolio’s volatility with bonds. But increasing the amount of bonds in your portfolio lowers your prospects for growth over time.
This simple trade-off is the nub of investing.
Our risk tolerance tends to decline with age though few retirement calculators take this into account.
This useful tool enables you to plot the effect of lifestyling your portfolio – that is, reducing its inherent risk as you get closer to retirement. Just adjust the sliders in the ‘Before Tax Return on Saving’ section to select lower growth rates as you age.
The rate your pension fund returns is one of the least controllable factors when saving for your old age, so be sure to consider all the other aspects of retirement planning to put yourself in the best possible position.