A half a percent that can change your retirement
Reprinted courtesy of MarketWatch.com
Published: Oct. 15, 2014
To read the original article click here
In my workshops and classes, I’ve started including a presentation on the lifetime impact of gaining an extra 0.5% of annual investment return. For most investors, this added return is easy to achieve.
In fact, if you fail to gain this extra return, I think you have made a huge mistake. It might seem like a small mistake — after all, in just one year the difference will hardly be noticed — but the consequences can be huge over an investment lifetime.
The key here is to think about the long term. Many investors habitually think in terms of what we gain or lose in a short period: a month, a quarter, a year, a decade — or even all the years until we will retire. The accumulation phase of investing, in other words.
But the advantages of an extra 0.5% in return don’t stop when you retire because your portfolio will continue working for you as long as you live.
With the help of an economics professor at Western Washington University, I calculated the long-term difference between earning a lifetime portfolio return of 8% and earning 8.5%. That’s a modest increase of about 6% in return in a single year.
But would you believe that seemingly small difference could boost your nest egg at retirement by 16%? Would you believe it could boost your retirement income by 24%? Would you believe it could boost the money you leave to your heirs by 31%? In each case, you should believe that.
Let’s look at some numbers:
If you save $5,000 a year for 40 years and make only 8% (the “small” mistake), you’ll retire with about $1.46 million. But if you earn 8.5% instead, you’ll retire with nearly $1.7 million. The additional $230,000 or so may not seem like enough to change your life, but that additional portfolio value is worth more than all of the money you invested over the years. Result: You retire with 16% more.
Your gains don’t stop there. Assume you continue earning either 8% or 8.5% while you withdraw 4% of your portfolio each year and that you live for 25 years after retirement. If your lifetime return is 8%, your total retirement withdrawals are just shy of $2.5 million. If your lifetime return is 8.5% instead, you withdraw about $3.1 million. That’s an extra $600,000 for your “golden years,” a bonus of three times the total dollars you originally saved.
Your heirs will also have plenty of reasons to be grateful for your 0.5% boost in return. If your lifetime return was 8%, your estate will be worth about $3.9 million. If you earned 8.5% instead, your estate is worth more than $5.1 million.
To sum this up, at 8% your initial savings (totaling $200,000) turn into $6,447,194 — the sum of what you take out in retirement and what you leave in your estate. At 8.5%, the comparable number is $8,283,312.
That difference, about $1.8 million, came only from the extra half-percentage-point of return.
If this seems like a desirable outcome, let me tell you three places you are likely to find such a deal.
The most obvious place, at least to me, is to invest in funds with lower expense ratios. A typical actively managed equity fund charges expenses of more than 1%. A typical index fund charges less than half as much. Bingo, you’ve got it done.
(I hope it goes without saying that you’ll rob yourself of at least 0.5% in annual return if you buy load funds.)
A second place you are likely to find an extra 0.5% is to bump up your equity allocation by 10 percentage points. For example, you would have achieved that from 1970 through 2013 by investing 60% in equities instead of only 50%.
A third source of higher returns that is extremely obvious to me: Adding equity asset classes that have long histories of outperforming the S&P 500 Index and the U.S. and international Total Market indexes. These include U.S small-cap stocks, U.S. large-cap value stocks, U.S. small-cap value stocks, international large- and small-cap value stocks, emerging-markets stocks and U.S. REITs.
This is known as diversification, and it’s one of the smartest things investors can do. For a more detailed discussion and specific recommendations, read this.
There are plenty of other smart moves that investors can make to boost their lifetime returns, but if you act on one or more of these three suggestions, you’ll likely add more than a half percentage point to your return.
There’s no question about it: That could significantly change your financial life.
Richard Buck contributed to this article.
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