In determining what to cover in our company’s blog, we frequently review the questions, and more importantly, the misconceptions our new clients often approach us with during educational events and appointments. One of the most common misconceptions we run into is the idea that as long as you average steady interest earnings (or rates of return) over a given period of years, you’ll ultimately reach your desired financial destination. Many individuals, for example, have been brought up with the belief that the market will generally average a given return – say 9-10% per year – over time. Of course, market research will prove otherwise, yet the misconception still exists.
To illustrate just how dangerous this mistake can be in creating a financial strategy for the future, let’s look at a quick example.
Kenneth is in his mid 30’s and is a planner by nature. He dreams of retiring with $1 million in his retirement savings. He clings to the belief that, over time, the market will average a 10% return over time because that’s what he’s always heard. He can easily do the math and determine that if he just sets aside $5,000 a year, he’ll reach his goal of $1 million when he retires at 65.
In fact, you can follow Kenneth’s plan below:
Beginning |
Annual |
Earnings |
Annual |
Ending |
|
Age |
Balance |
Contribution |
Rate |
Earnings |
Balance |
|
|
|
|
|
|
35 |
$0 |
$5,000 |
10.00% |
$500 |
$5,500 |
36 |
$5,500 |
$5,000 |
10.00% |
$1,050 |
$11,550 |
37 |
$11,550 |
$5,000 |
10.00% |
$1,655 |
$18,205 |
38 |
$18,205 |
$5,000 |
10.00% |
$2,321 |
$25,526 |
39 |
$25,526 |
$5,000 |
10.00% |
$3,053 |
$33,578 |
40 |
$33,578 |
$5,000 |
10.00% |
$3,858 |
$42,436 |
41 |
$42,436 |
$5,000 |
10.00% |
$4,744 |
$52,179 |
42 |
$52,179 |
$5,000 |
10.00% |
$5,718 |
$62,897 |
43 |
$62,897 |
$5,000 |
10.00% |
$6,790 |
$74,687 |
44 |
$74,687 |
$5,000 |
10.00% |
$7,969 |
$87,656 |
45 |
$87,656 |
$5,000 |
10.00% |
$9,266 |
$101,921 |
46 |
$101,921 |
$5,000 |
10.00% |
$10,692 |
$117,614 |
47 |
$117,614 |
$5,000 |
10.00% |
$12,261 |
$134,875 |
48 |
$134,875 |
$5,000 |
10.00% |
$13,987 |
$153,862 |
49 |
$153,862 |
$5,000 |
10.00% |
$15,886 |
$174,749 |
50 |
$174,749 |
$5,000 |
10.00% |
$17,975 |
$197,724 |
51 |
$197,724 |
$5,000 |
10.00% |
$20,272 |
$222,996 |
52 |
$222,996 |
$5,000 |
10.00% |
$22,800 |
$250,795 |
53 |
$250,795 |
$5,000 |
10.00% |
$25,580 |
$281,375 |
54 |
$281,375 |
$5,000 |
10.00% |
$28,637 |
$315,012 |
55 |
$315,012 |
$5,000 |
10.00% |
$32,001 |
$352,014 |
56 |
$352,014 |
$5,000 |
10.00% |
$35,701 |
$392,715 |
57 |
$392,715 |
$5,000 |
10.00% |
$39,772 |
$437,487 |
58 |
$437,487 |
$5,000 |
10.00% |
$44,249 |
$486,735 |
59 |
$486,735 |
$5,000 |
10.00% |
$49,174 |
$540,909 |
60 |
$540,909 |
$5,000 |
10.00% |
$54,591 |
$600,500 |
61 |
$600,500 |
$5,000 |
10.00% |
$60,550 |
$666,050 |
62 |
$666,050 |
$5,000 |
10.00% |
$67,105 |
$738,155 |
63 |
$738,155 |
$5,000 |
10.00% |
$74,315 |
$817,470 |
64 |
$817,470 |
$5,000 |
10.00% |
$82,247 |
$904,717 |
65 |
$904,717 |
$5,000 |
10.00% |
$90,972 |
$1,000,689 |
It all looks simple enough, right? Kenneth starts saving right away, faithfully dropping his $5,000 per year into the plan, and as far as he can tell, he’s perfectly on track.
Now remember, Kenneth is a planner so he’s constantly tracking his progress. For the first several years, he’s actually ahead of the game, earning over 10% – things seem so easy! In fact, by the time he hits the 20-year mark, he’s already racked up almost $600K. He doesn’t even have to double his account value over the next 10 years. Given the numbers, he’s actually kicking around the idea of early retirement!
Then something strange happens. The markets stop doing so well.
Values start dropping and not bouncing back as quickly as they once did. In fact, during the final 10 years of Kenneth’s “plan,” he actually ends up netting a 0% rate of return. He ends up with $562K in his account after 30 years instead of the $1 million he planned, yet, when he does the math to find out what he actually averaged over those 30 years, he uncovers 9.68% – very close to his 10% figure. So what happened to the “plan?”
A rule that many individuals don’t take into account when looking at their retirement earnings: sequence of returns.
Kenneth was making great returns when his account balance was small, but once his account got larger, his returns were poor. Big returns on small amounts of money were quickly trumped by small returns on large amounts of money. This is a real issue which impacts real people every day.
Take a look at a hypothetical example of someone turning 35 in 1980 and investing in the S&P 500.
Beginning |
Annual |
Earnings |
Annual |
Ending |
|
Age |
Balance |
Contribution |
Rate |
Earnings |
Balance |
|
|
|
|
|
|
35 |
$0 |
$5,000 |
25.77% |
$1,289 |
$6,289 |
36 |
$6,289 |
$5,000 |
-9.73% |
-$1,098 |
$10,190 |
37 |
$10,190 |
$5,000 |
14.76% |
$2,242 |
$17,433 |
38 |
$17,433 |
$5,000 |
17.27% |
$3,874 |
$26,307 |
39 |
$26,307 |
$5,000 |
1.40% |
$438 |
$31,745 |
40 |
$31,745 |
$5,000 |
26.33% |
$9,676 |
$46,422 |
41 |
$46,422 |
$5,000 |
14.62% |
$7,518 |
$58,940 |
42 |
$58,940 |
$5,000 |
2.03% |
$1,296 |
$65,236 |
43 |
$65,236 |
$5,000 |
12.40% |
$8,710 |
$78,946 |
44 |
$78,946 |
$5,000 |
27.25% |
$22,876 |
$106,822 |
45 |
$106,822 |
$5,000 |
-6.56% |
-$7,335 |
$104,487 |
46 |
$104,487 |
$5,000 |
26.31% |
$28,802 |
$138,290 |
47 |
$138,290 |
$5,000 |
4.46% |
$6,397 |
$149,686 |
48 |
$149,686 |
$5,000 |
7.06% |
$10,913 |
$165,600 |
49 |
$165,600 |
$5,000 |
-1.54% |
-$2,626 |
$167,974 |
50 |
$167,974 |
$5,000 |
34.11% |
$59,002 |
$231,976 |
51 |
$231,976 |
$5,000 |
20.26% |
$48,020 |
$284,996 |
52 |
$284,996 |
$5,000 |
31.01% |
$89,923 |
$379,919 |
53 |
$379,919 |
$5,000 |
26.67% |
$102,652 |
$487,571 |
54 |
$487,571 |
$5,000 |
19.53% |
$96,180 |
$588,751 |
55 |
$588,751 |
$5,000 |
-10.14% |
-$60,201 |
$533,549 |
56 |
$533,549 |
$5,000 |
-13.04% |
-$70,241 |
$468,308 |
57 |
$468,308 |
$5,000 |
-23.37% |
-$110,593 |
$362,715 |
58 |
$362,715 |
$5,000 |
26.38% |
$97,005 |
$464,720 |
59 |
$464,720 |
$5,000 |
8.99% |
$42,244 |
$511,964 |
60 |
$511,964 |
$5,000 |
3.00% |
$15,514 |
$532,478 |
61 |
$532,478 |
$5,000 |
13.62% |
$73,201 |
$610,679 |
62 |
$610,679 |
$5,000 |
3.53% |
$21,731 |
$637,410 |
63 |
$637,410 |
$5,000 |
-38.49% |
-$247,237 |
$395,173 |
64 |
$395,173 |
$5,000 |
23.45% |
$93,857 |
$494,031 |
65 |
$494,031 |
$5,000 |
12.78% |
$63,790 |
$562,821 |
Average: |
9.68% |
The moral of the story? You can achieve your target rate of return and still fail miserably with your planning. In this example, Kenneth leaned on a big “MAYBE” in his approach to retirement: Maybe he’d succeed. The problem was it all depended on variable he didn’t control.
We believe that as you near retirement, sound financial strategy involves turning “maybes” into certainties – removing chances for failure and replacing them with true guarantees* such as those found in fixed or fixed index annuities. If you’d like to know more about how you can “insure your financial future,” simply contact us today!
*Guarantees on insurance and annuity products are subject to the financial strength and claims-paying ability of the issuing insurer.
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