All across the personal finance blogosphere, I hear people using 7% in their retirement calculation, or if someone is feeling really greedy, 8%. They say that this is the average after-tax rate our investments earn over a long period of time.
But guess what? We don’t have to use that 7% for every calculation. It’s sort of arbitrary and while it may have been useful as a baseline to many, I think we need to increase that by a percentage point or two for future calculations. We can’t predict the performance of our investments over the next 1, 5, 10, or 20 years. But we can use educated guesses and some historical data to estimate what the most likely scenarios will be. For most young people like me, we have 30-40 years until we retire and having even a vague idea of what our investments will do over a long period of time is helpful in planning.
I choose not to believe in that 7% number, for a few reasons:
- The 7% number comes not from standard market returns, which over a 30 year period averages between 9% and 10% annually (check out 25 year averages here). As a conservative estimate, taxes reduce the effective rate to about 7% after taxes. However, young people who start saving and use that long-term number should have savings in a Roth IRA, which allows money to grow tax free, so that pre-tax index number of 9-10% is actually more relevant in that case.
- Taxes are currently on the low end historically, and this is true of long-term capitals gains rates as well. If 7% was derived when taxes were higher (and more uncertain, the current low tax rates have recently been made permanent), it follows that a smaller percentage of those average earnings would go to taxes.
- Not all investments track the market index and technology has allowed for new, creative investment vehicles. I have been using Lending Club for part of my investments to the tune of a very consistent 11% interest rate (and the rate of return with peer-to-peer lending has been very consistent overall, even through a recession). Even with taxes taken out (I invest in a Roth IRA for a double win), there are new investment vehicles that may help us boost that number. Heck, my investments in blogs is well over 500% (thought it’s not nearly as scalable), so while 9-10% may be average, who’s to say it can’t be even higher?.
Sure, people want to be careful when making projections about returns over long-term periods of time so that they don’t run out of money. That’s totally understandable and being on the conservative side when making predictions about retirement, is probably a good idea. It’s far better to be careful and not run out of money in your 80s or early 90s than to be over-confident in our estimates and risk a crisis when there’s not enough savings to last.
7% may have been the old number to use for every calculation, but the rules have changed. I’m not suggesting we use 10% in every calculation, but I think 8-9% is still a safe number to use for planning, and as we know, even small increases in interest rates will have colossal effects on savings over a long period of time.
I would rather use 7% or less, and be pleasantly surprised. It is hard enough to guess where the market will go, so unless it is a just for fun prediction, if I need to depend on it and plan with it for a safe future, I’d go with the smallest number.
@Pauline, I agree with you. It would be better to have more money than planned, rather than less. You can always change you plans if you end up with more money that anticipated.
You bring up some great points and I agree that we shouldn’t be locked into expecting a certain percentage or another as some things have changed. I tend to be on the lower end of the projection because I’d rather be conservative and surprised by having more in the long run.
I agree with Pauline and John. Why not use 7%? If you use that and you get that, then you won’t be disappointed. If you use it and you get more, then that would be a nice surprise. If you try to use more and you never reach it, then you will constantly be disappointed.
@Grayson @ Debt Roundup, Why use 7%? Why not 5% or even 3%? My point is that while it’s ok to be conservative, that 7% has no real basis and that maybe 9% is more realistic.
I agree with what have said. There are even some mutual funds with long track records that have gotten an average return of 11-12% a year. So why can’t we expect that in the future for these funds? I tend to agree with Pauline that being conservative is probably best, but creating an ideal scenario with the 8-10% range you suggested would be a good idea.
Unreasonable expectations usually set you for failure or at the very least disappointment. I expect on average that I will achieve 8-10% over the next 35 years. If I get more, it is gravy.
The 7% rule of thumb seems not to account for fluctuations in financial technologies, as well (e.g. Roth IRAs). Great insight here.
I think its better to be a little conservative then be expecting and have a big surprise waiting. Its crazy enough that most don’t understand compound interest and focus too much on short term. Then they see good returns and the minute there is a down the are ready to get out of the investment. It has to be there long enough to actually average the return whether 7 or 10%.