Why “Rate of Return” is Meaningless When You’re Retired

The Problem

You’re about to re­tire, you’re go­ing to be liv­ing off a nest egg that took decades of sav­ing and in­vest­ing to build.

Now it’s time to de­cide what you’ll be in­vest­ing in to sus­tain that nest egg well into your golden years al­low­ing you to travel, en­joy life, main­tain your­self if you re­quire ad­di­tional help, and, hope­fully, leave a bit to your chil­dren and grand chil­dren.

The gen­eral rule of thumb is that you can draw about 4-5% from your in­vest­ment pool on an an­nual ba­sis to sup­ple­ment your gov­ern­ment pen­sions whilst main­tain­ing your re­tire­ment port­fo­lio with­out the risk of de­plet­ing your fi­nances.

But wait, who came up with that rule of thumb in the first place? Your mom is 90 and she’s not in bad shape at all. Heck, it’s not in­con­ceiv­able that she may live to 100.

Medicine has im­proved since that “rule of thumb” was cre­ated. Seniors are ac­tive, they work out, they take courses to stim­u­late their minds, they have ac­cess to ex­cel­lent health care: Simply put, they live longer than ex­pected.

A 30-year re­tire­ment is not unimag­in­able any­more. What about in­fla­tion? Will your money last that long? Will you have to sell your house and down­size?

You start crunch­ing num­bers. GICs are pay­ing any­where from 1-2.5% now (2022), gov­ern­ment bonds aren’t much more at­trac­tive. Savings ac­counts? Don’t even talk about those, they’re a joke.

All these “safe” in­vest­ments are pay­ing less than in­fla­tion af­ter tax.

That’s when you start look­ing at al­ter­na­tives. Maybe stocks? Some have div­i­dends ex­ceed­ing 5%.

Maybe real es­tate? Too bad you don’t have enough for a down-pay­ment, and con­dos in Toronto aren’t even cash-flow pos­i­tive for the most part.

You’re con­fused.

Exactly what rate of re­turn do you need to sup­port your­self through a po­ten­tially long re­tire­ment?

Why “Rate of Return” is Actually Meaningless

Let’s look at two in­vest­ment op­tions.

John, age 65 and in good health, has $1,000,000 saved in his re­tire­ment port­fo­lio. He would like to draw $50,000 per year ad­justed for in­fla­tion, on an an­nual ba­sis from this port­fo­lio to sup­ple­ment his CPP and OAS pen­sions.

He has two op­tions:

1. Portfolio 1 has a his­tor­i­cal com­pound, an­nual rate of re­turn of 8.2%
2. Portfolio 2 has a his­tor­i­cal com­pound, an­nual rate of re­turn of 8.2%

Which one should he go for?

Right now, you’re ask­ing your­self if this is a trick ques­tion. They both have the same long-term rate of re­turn, so they’re the same, right?

WRONG.

Let’s take a closer look…

Although they have the same long-term per­for­mance (8.2% com­pound an­nual re­turn) they have dras­ti­cally dif­fer­ent out­comes.

Take a closer look. Portfolio B starts off strong, while port­fo­lio A starts off with sig­nif­i­cant losses.

Portfolio B is the ex­act in­verse of port­fo­lio A. Strong at first but fin­ishes with losses in the end.

The early losses suf­fered by port­fo­lio A have a sig­nif­i­cant ef­fect on the longevity of John’s re­tire­ment port­fo­lio. In fact, he runs out of money by age 79.

In com­par­i­son, port­fo­lio A al­lows John to sus­tain him­self with an in­creas­ing draw every year un­til his even­tual pass­ing at age 90. It even al­lows him to leave his chil­dren over $4,400,000 at death, over 4-times what he ini­tially in­vested even though he en­joyed over $1,800,000 of ad­di­tional in­come over the course of his 25-year re­tire­ment.

The chart be­low demon­strates this vi­su­ally:

So, What’s the Lesson Here?

The over­all les­son is this: It’s more com­pli­cated than you think.

Looking at his­tor­i­cal re­turns ONLY is a huge mis­take that many re­tirees and in­vestors make.

Returns must be viewed in con­text. You must con­sider:

• Variation of re­turns
• Risk of loss
• Annual with­drawals

Among many more fac­tors.

How Do I Avoid These Problems?

There are sev­eral ways you can avoid these prob­lems, many of which will be top­ics in fu­ture blog posts:

Diversification of in­vest­ments:

You can di­ver­sify be­tween long-term as­sets such as stocks and blend in some lower risk as­sets such as short-term debt, GICs, cash sav­ings etc. which can dampen short term losses on your port­fo­lio and fund your more cur­rent needs.

Choose lower volatil­ity in­vest­ments:

You can al­lo­cate your port­fo­lio to lower volatil­ity in­vest­ments such as low du­ra­tion fixed in­come and sim­i­lar in­vest­ments. However, you will be sac­ri­fic­ing long term gains for this type of strat­egy and run the risk of out­liv­ing your money.

Use Insured Products:

Insurance in­vest­ments, such as seg­re­gated funds and re­lated prod­ucts pro­vide many fea­tures such as prin­ci­pal guar­an­tees, re­turn guar­an­tees and sim­i­lar in­vest­ment fea­tures that many re­tirees find at­trac­tive. These prod­ucts tend to have a higher price tag than tra­di­tional in­vest­ment ve­hi­cles but can of­fer peace of mind.

The bot­tom line: It’s more com­pli­cated than you think, and a full analy­sis should be un­der­taken be­fore you pull the trig­ger on any re­tire­ment strat­egy.

Fabio Campanella CPA, CA, CFP, CIM is an in­de­pen­dent in­vest­ment ad­vi­sor with Queensbury Securities Inc. along with be­ing the CEO of The Campanella Group. He has helped hun­dreds of fam­i­lies plan their tax, in­vest­ment, and es­tate strate­gies since 2002.

If you’re ready to take the next step in your fi­nan­cial jour­ney then con­tact us for a zero-cost 30-minute, on­line meet­ing where we can get to know you and de­ter­mine if we can help you pave a path to­ward fi­nan­cial suc­cess.