In its most recent survey of corporate pension accounting, Hewitt reports that the average assumed long-term rate of return at year-end 2008 is 7.98%. That’s the number that companies estimate they’ll earn annually on their pension investments; they use that guess to help decide how much they must invest today to pay future benefits. While 7.98% is lower than the 8.34% assumed rate in 2004, it still seems a tad optimistic when viewed through “new normal” binoculars. Stocks aren’t expected to earn much more than 8%, and there’s little reason to expect bonds will post returns beyond their 5% historical long-term average. (In fact, given where we are in the interest rate cycle, 5% might be optimistic.)
Even before the credit crisis fallout, there was plenty of skepticism about corporate pension assumptions. In the 2007 Berkshire Hathaway shareholder letter Warren Buffett stepped through yet another of his clear-eyed market/math lessons that pointed out the long-term trend is for stocks (net of expenses) to earn around 7% and bonds 5%. Plug that into a 70/30 stock-bond mix (typical for pension funds) and you get a return closer to 6.5% than 8%.
I am going to leave the world of pension funding/underfunding and switch gears to what matters more for many of us: The rate of assumption we have for our self-managed 401(k) and IRA retirement assets. After all, most of us aren’t covered by traditional pensions. And that leads me to ask the question: What’s your assumed rate of return? (See the poll below.)
Beware of the “garbage in, garbage out” trap. The higher the rate you use, the higher the risk you run of falling short. First off, there’s the problem of high expectations falling short of real-world returns. Second, when you assume a high rate of return it often becomes an excuse to contribute less. And to be sure, after the 18% annualized gain for the S&P 500 in the 1990s it was easy to assume the markets would do most of the heavy lifting for our retirement.
Consider how different rates of return would impact a $250,000 retirement portfolio today. (Assume no additional contributions.)
In 15 years, the $250,000 would be worth:
• $2.99 million @ 18% assumed rate.
• $1.04 million @ 10% assumed rate
• $793,000 @ 8% assumed rate
• $643,000 @ 6.5% assumed rate
So, what rate are you banking on? To see the impact of different assumptions, check out this calculator where you can adjust your contributions and assumed rate of return. And keep in mind the advice of Steve Utkus, chief of Vanguard’s Center for Retirement Research: “Contributions need to be higher than many of us imagined. Markets, averaged out over good and bad periods, are now recognized to play a smaller role.” Are you ready to pony up more?