Lower expected returns mean saving more — or retiring later

Further to Tuesday’s blog on “saving too much” comes a study from the C.D. Howe Institute that gives retirement savers a “reality check” on projecting future investment returns. Just as the mutual fund ads are supposed to warn investors that “past returns are no guarantee of future results,” so does the C.D. Howe study remind us that “relying on historical performance to inform long-run return forecasts in pricing future pension liabilities is almost certain to be misleading.”

As mentioned at the end of the previous blog, C.D. Howe is predicting long-term nominal returns of 2.5% for long-term bonds, or a paltry 0.5% after 2% expected annual inflation. For stocks, the outlook is a bit brighter: 6.9% nominal returns or 4.8% real returns (net of inflation.) In between, a 50/50 balanced portfolio would have an expected nominal return of 4.7%, or 2.7% after inflation.

Already low returns could be lower still

However, returns could be better or worse in reality. There is a 25% probability returns will be lower by two percentage points over a 10-year time horizon and by one percentage point over 30 years. Individual savers could also lose one percentage point to expensive investment management fees, whether in RRSPs or Defined Contribution pension plans. Using these “more realistic” return expectations also means “individuals should save more for their retirement to avoid a larger-than-expected drop in their retirement lifestyles,” write the report’s co-authors, Richard Guay and Laurence Allaire Jean.

They warn pension administrators to avoid using past returns to project future pension returns. For example, 20 years ago, long-term government bonds sported yields of 10%, compared to only 5% a decade ago and more recent yields in the range of 2 to 3%. The report’s authors do not believe it likely that interest rates will climb back from these historic low levels, even after there is a full global economic recovery.

50% more saving needed under gloomier scenarios

The authors analyze income replacement levels of 50%, 70% and 100% at retirement and come to the sobering conclusion that “in a lower, more realistic real-return environment of 2.66%, the saving effort necessary to achieve the same income replacement is quite higher than under more optimistic expectations.” As an example, to generate an annual retirement income of $50,000 or more, the required savings rate is almost 1.5 times greater than under a more optimistic forecast. To reach the common target of 70% income replacement for a $50,000 final income, the necessary savings rate over 30 years jumps from 9.6% to 14% of annual gross salary.

The alternative, as I said in Tuesday’s blog, is to take on more risk. Or, as the paper suggests, “one way to mitigate investment risk is to delay retirement, extending the career and savings period.” For example, if you retire at the new OAS age of 67 instead of 65, the required savings rate would fall from 14% to 11.2%.

Which is why C.D. Howe used the phrase “reality check.”

About Jonathan Chevreau

As MoneySense’s Investing-Editor-at-Large, he is also author of Findependence Day and co-author of Victory Lap Retirement. Reach him at [email protected], where he is the founder of Financial Independence Hub.

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