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What annual rate of return should you expect from your pension fund?

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.

High return (9 per cent) pension projection

Growth rate 7% per year over 35 years.
Projected retirement income = £14,000 p.a.

Medium return (7 per cent) pension projection

Growth rate 5% per year over 35 years.
Projected retirement income = £7,000 p.a.

Low return (5 per cent) pension projection

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.

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{ 15 comments… add one }
  • 1 Jonny August 10, 2012, 1:17 pm

    Just wanted to post to thank you for the retirement posts this week. They’ve been really informative and helpful, and will act as a great reference when reviewing my pension plans from time to time…

  • 2 The Accumulator August 10, 2012, 1:22 pm

    That’s great news, Jonny. I’m glad it’s useful stuff, otherwise there wouldn’t be much point.

  • 3 gadgetmind August 10, 2012, 1:37 pm

    In the advanced options of that calculator, you can also play with the levels of fees. As you’d expect, 1% fees is the same as 1% less return, which is why keeping fees as low as possible is important.

  • 4 Neverland August 10, 2012, 3:22 pm

    Inflation deceives to flatter all pension projections

    I put the real 5% return on equities and a guessed real 1.5% return on a basket of bonds (in normal markets conditions) for someone starting a pension at 30 and retiring at 65 with a risk curtailment strategy starting at 50 into the liefstyling tool linked above

    2/3 of the inflation adjusted value of their fund came from their contributions, only 1/3 came from investment gains

    Its all about how much you save, how early you start and not paying fees

  • 5 Paul S August 10, 2012, 4:29 pm

    Hi TA,

    Nice thought provoking series. I am concerned at this assumption that bonds reduce risk. In the present situation bonds are highly risky…..I recommend a read of “The Bond Conundrum” on the Hargreaves Lansdown website. You might also have caught the Telegraph story that M&G have sent a memo to their agents telling them to stop selling their bond funds. They could be worrying about a misselling scandal if the bond market crashes.

    Even in “normal” situations the safety of bonds is greatly overplayed. Risk, in the investment sense, is just volatility. As Jeremy Siegel shows in “Stocks for the Long Run” bonds only have a lower volatility than stocks over a fairly short investment period. Once the investment timeframe is over 10-15 years equities are no more, and even less, volatile than bonds.

    In return for the perceived safety of bonds the investor accepts a greatly reduced investment return. The average real return on UK stocks from 1900 to 2006 was 5.6%pa. On government bonds it was 1.3%pa. (data after Siegel). That is a 15yr real profit for stocks of 125% vs 22% for bonds.

    In reality the situation is even worse as the dreaded expenses take, proportionally, a bigger chunk out of the profits. The mantra of moving out of stocks into bonds as you get older seems to me to be no more than that, a mantra. Even when you retire you still expect (or hope) to have investments for the next 20 or 30 years.

  • 6 gadgetmind August 10, 2012, 5:54 pm

    With only a 10% allocation, I am very light on bonds given how (hopefully!) close to retirement I am. However, I am using corporate bond ETFs to give me agility with low fees, and I’m using some lower volatility equities to further reduce volatility.

  • 7 DBSausage August 10, 2012, 7:29 pm

    I’ve really enjoyed the retirement special on Monevator this week – much food for thought! Thanks! 😀

  • 8 ermine August 11, 2012, 10:25 am

    I’ve also enjoyed this series, it’s fantastic- well done!

  • 9 Geo August 13, 2012, 8:42 am

    Interesting thoughts on life styling Paul S, I have always wondered ho much sense it makes to move money into bonds when the key to riding out volatility in equities is to keep things in there for longer…

    Say you invest at 30 into equities then that money after 30 years theoretically should be safe as you have ridden out potential drops that would affect the value, even if there is another drop and got an equity return. By constantly moving that money towards bonds you in effect take away the chance of the higher return.

    It seems to me that maybe only new money should be slowly allocated to bonds or some similar strategy but at the moment I’m not sure what! trying to be too clever usually doesn’t work out well for me!

    Ignore MG news by the way as Richard Wollnough(?), the don there, poo pooed that comments and said he can still make money, its just their bonds funds have got too big to manage.

  • 10 The Investor August 13, 2012, 11:21 am

    Thanks for the positive comments, guys, glad you enjoyed the series!

    We covered the bond conundrum quite recently. I currently own zero government bonds, and I feel safer for it. I think cash is a sensible alternative for more actively-minded investors, or even passive ones prepared to get a bit hands on.

    However as I’ve said before I think we shouldn’t overplay the risk. If I buy a ten-year UK government bond today and hold until it matures, I am guaranteed to make a positive (nominal) return on the gross redemption yield. That is very different to equities, where there are no guarantees. That is why bonds reduce risk, in any environment.

    Are they an attractive investment? Not for me, not at all, but for many they are there to do a job. (Protect against deflation, principally. See Japan).

    Also, it may seem obvious bonds are ludicrously over-valued, but they can get more ludicrously over-valued. I first worried about a government bond bubble forming in late 2008! Even though shares have indeed done better, the fact is government bonds have done well, too.

    It’s four years on and it may seem more obvious now, but little (especially timing!) is ever a slam dunk in the markets, IMHO.

  • 11 The Accumulator August 13, 2012, 8:53 pm

    @ Geo and Paul S – your money is never safe in equities. If you’ve done really well then a move into government bonds takes some of that risk off the table. If you’ve done really badly but can’t afford to lose any more then again, bonds are one way of reducing risk. Bear in mind, reducing risk (i.e. reducing volatility) does not equate to safety.

    It’s better to think of the issue in terms of your overall portfolio rather than banking the farm on the asset class with the greatest chance of high returns. There’s no reward without risk.

    A mix of equities and bonds is more diversified and helps protect you against a scenario like deflation or Japan or even just a bad few years for equities.

    Equities less volatile than bonds? Only in terms of the historical average. In terms of what your portfolio could do this year, equities could plunge 30% whereas it’s highly unlikely government bonds would experience a fall into double figures. That’s why bonds belong in the portfolio of anyone who’s likely to panic in the face of a major market tailspin. With any luck your gilts will be your parachute.

    Bond market crashes are not like stock market crashes. Take a look at this piece by Vanguard to see how quickly your bond allocation is likely to recover:
    https://advisors.vanguard.com/iwe/pdf/ICRROL.pdf?cbdForceDomain=true

  • 12 Ash G August 14, 2012, 5:00 pm

    Thanks for these scenarios, the one you’ve outlined above is spookily familiar to me. I’ve been playing with the fund calculator most of the afternoon and I can conclude I need a bigger salary 🙂

  • 13 The Investor August 14, 2012, 9:13 pm

    In terms of what your portfolio could do this year, equities could plunge 30% whereas it’s highly unlikely government bonds would experience a fall into double figures.

    For the record, I’m not so sanguine about gilts as my esteemed co-blogger. 🙂 A 1% rise in the ten-year rate would knock about 10% off the price of the gilt at these low yield levels, by my estimates. A swift rise to 4% could knock off 20% of the value of a ten-year gilt. I don’t think gilts at 3% is beyond the realms of possibility within the next couple of years.

    You can model your own doomsday scenarios using this handy calculator.

    This doesn’t change my overall view that passive asset allocators shouldn’t suddenly flee the asset class, or that it’s not helpful to talk about gilts as being ‘risky’ in the same sense as equities. It’s all about certainty (okay, very near certainty!) of capital return and income.

    UK Gilt Treasury Stock 2021 currently has a price of 118.76. It will redeem at 100, so the capital loss is baked in, and indisputable. The redemption yield is 1.6 per cent though, which implies a positive return of 1.6% per annum if held to maturity, thanks to reinvesting the annual coupon.

    1.6% per annum over a little under 10 years isn’t my idea of a great return (and as I say I don’t own any gilts) but it is secure.

  • 14 Paul S August 15, 2012, 10:47 am

    TI, That is a secure nominal 1.6%pa which is almost certainly a secure real loss. Probably about -1%pa or so. Not the investment result I am looking for……..

  • 15 David August 19, 2016, 9:56 am

    Historically, I believe FTSE 100 has delivered around 6.5%/annum with dividends reinvested, however given it seems to have maxed out at 7000 since the turn of the century, I suspect it is probably closer to 4-5%/annum these days. However, I believe in that the next 10-15 years the FTSE100 will hit 10000 (even if it drops to below 5000) on the way. So growth should exceed 7%/annum in this period. With this sort of growth and associated volatility, you will need to pay close attention to the lifetime allowance of £1 million. May even be worth turning most of the pot into cash until you are over 75. It’s ironic that these changes could encourage more risk taking at an age when less should be taken.

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