Required Returns

Published On: September 29, 2023

Written by: Ben Atwater and Matt Malick

Many of our clients are investing with retirement as their primary goal. They want income, or cash flows from their portfolios, to fund a certain retirement lifestyle. And they hope to avoid running out of money. As one client put it to us recently, “keep us out of the poor house.”

But how do we connect a portfolio of investable assets to this goal of retirement income? What is the required rate of return to achieve it?

Each client’s circumstances are unique, with different portfolio values, lifestyles and budgets. But in most cases, there is a required rate of return that aligns with a client’s goal of sustaining a portfolio throughout retirement.

As an example, let us consider an investor with a $3 million portfolio of investable assets. This investor needs $90,000 of “income” per year to sustain their lifestyle, which equals a 3% spending rate.

$3,000,000 x 3% = $90,000

But if we account for income and capital gains taxes on portfolio withdrawals, using a ballpark average tax rate of 20%, then the spending rate would climb to 3.75%.

$3,000,000 x 3.75% = $112,500

$112,500 x 20% taxes = $22,500

$112,500 – $22,500 = $90,000

However, a $90,000 budget today will not go as far in future years as it does now. According to our retirement planning software, MoneyGuidePro, inflation since 1990 has been 3.47% (CPI-U). Based on this rate of inflation, a $90,000 budget today would require $126,586 in ten years.

In other words, if our investor wants to maintain the buying power of the portfolio while holding their spending rate steady at 3.75%, then we must add inflation to our required rate of return. In this case, the required rate of return is 7.22%, including taxes.

3.75% + 3.47% = 7.22%

Many clients hope to maintain the purchasing power of their portfolios to pass along a healthy inheritance to their heirs. Others want to maintain a large cushion to guard against end-of-life expenses. Some are simply nervous seeing their portfolio shrink.

But some clients implement a spending rate that, when added to inflation, exceeds the expected growth rate of their portfolio. In these cases, we expect to see a deterioration in the buying power of the portfolio over time. In some cases, the spending rate is temporary and will decline once the client claims Social Security. Or the client is not concerned with leaving an inheritance and just wants to spend their hard-earned savings. In this vein, another client once told us, “I hope to spend my last dollar on my deathbed.”

We cannot overstate the importance of examining each client’s unique circumstances. In addition to an investor’s unique budget and spending rate, clients have different personal inflation rates. For example, if an investor enters retirement with a large outstanding mortgage, that payment is likely fixed, and the investor will have a lower overall inflation rate than another retiree who spends all their income on food, entertainment, healthcare and travel.

And vitally, investors have varying levels of risk tolerance and respond quite differently to market volatility and short-term portfolio losses. A portfolio strategy that one client uses to achieve a certain required rate of return may not work for another client. Strategies that can earn higher rates of return over the long-term are the same strategies that have high volatility in the short-term.

If you would like to discuss your own required rate of return, risk tolerance and review our long-term strategy to achieve your goals, please do not hesitate to contact us.