What to Expect from Expected Returns

In addition, understanding how those assumptions translate into the real world is critical to measure how your actual experiences compare to what was planned.

The rate of return expected on your investments is a key input into any financial planning model. That rate of return determines both how your assets are assumed to grow towards retirement, as well as how much income they might generate throughout retirement. The return assumption that is used in planning should ultimately be net of all fees that you pay: in other words, the actual return you are going to keep. Understanding your investment returns and what fees you are paying will help provide a basis for evaluating how you are doing against your plan.

In the last issue of Nexus Notes we provide details of our latest financial planning assumptions when it comes to rates of return:

Note: the rate of return assumptions are nominal and before investment management fees.

Blending Expected Rates of Return

The returns above represent the return on each potential component of a portfolio, not the expected return of the portfolio as a whole. For example, while our return projection on equities is 6.5%, a typical client invested in our Balanced Fund should anticipate lower returns as that fund includes a portion of bond holdings. As a result, the Balanced Fund would project returns of approximately 4.9% based on the 35% of its assets invested in fixed income and cash. It’s important to reiterate that these return assumptions don’t include the impact of expenses, as the investment management fee paid will be different for each individual. We provide a separate assumption for each client based on their average management and custody fees plus applicable taxes.

Financial planning can provide many benefits, including aiding in investment decisions and providing insight into what type of portfolio will meet a client’s needs. Planning can also help underline the importance of reasonable expectations by outlining what a realistic return expectation for a given portfolio might be, and if that will allow you to achieve your long-term goals.

It might be tempting to think of the asset projections in your plan as an annual report card against which to check your actual performance. While there can be some directional benefit to this, it’s important to realize that this isn’t a perfect comparison. A plan encompasses a long period of time and utilizes average annualized returns. As a result, the volatility that comes with investing gets smoothed out in the numbers that are presented in the plan.

Whether returns in any given year are higher or lower than the long-term rate of return assumed in the plan matters much less than how your portfolio performs on average over the long run.