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The Most Important Factor for Your Retirement Isn’t Rate of Return

By on March 8, 2012 in Money

The Most Important Factor for Your Retirement Isn't Rate of ReturnEarning a significant return on your investments is not the defining factor of a healthy retirement. Does that surprise you?

Of all the hype and marketing mutual fund companies give to how well their funds performed against their Lipper averages, it really isn’t as important as you would think. (Plus, companies cheat on their marketing by closing poorly performing funds and merging them into other successful funds.)

If rate of return isn’t the most important thing, what is?

The Two Key Factors for Your Retirement

There are two critical aspects that will make or break your retirement.

Your income

How much money you earn throughout your working career has a dramatic impact on your retirement. The more money you make, the more money you have to save and invest for retirement. If you always make $30,000 per year it is going to be challenging to save even $10,000 per year toward retirement. On the other hand if you make $120,000 per year saving $10,000 should be a breeze.

How much you save

The more money you save for retirement, the less you need to rely on a high rate of return to grow your nest egg. Using the example above, if you save 10% of your income for retirement that is only $3,000 if you make $30,000 per year. For the person making $120,000 per year that is $12,000. Of course if you make $120,000 per year and you blow it on frivolous things and still only save $3,000, you are no better off than if you had scrimped and saved on your $30,000 income.

Let’s take the example a step further (and ignore inflation): the two individuals make their incomes for 30 years and save 10% of their income every year. Over that time frame the $30,000 person saves up $90,000 in principal. The $120,000 person saves up $360,000 in principal.

For the first person to catch up to the second person the would need to earn a return of 7.89% every year for 30 years while the second person earned 0%. That’s just to go from $120,000 saved to $360,000 saved. With stocks earning on average 8-9% over the last 50 years, it would be possible for the first person to catch up based on the return of the investment… but remember, we were assuming the second person didn’t generate any return for 30 years. The required rate of return to catch up if the $12,000 saver had earned even 5% every year jumps from 7.89% to 12.2%. You would have to take on substantial risk just to catch up to a person who saved more money in a significantly more conservative and less volatile portfolio.

Change Your Focus

This information should help you change your focus from chasing the highest return possible to changing your lifestyle to save as much money as possible. The more you save the less risk you have to take to get to the same goal. If you earn high returns along the way, even better, maybe you can retire earlier than expected or have more to spend each year in retirement. But you don’t bank on the fact that you’ll have high returns.

Do Rates of Return Matter At All?

This isn’t to say that the rate of return on your portfolio isn’t important at all… it just isn’t the most important factor. Mutual fund companies that charge high expense ratios bank on the fact that you’ll bite on above average returns. The tweak their numbers to make everything look good.

But if you aren’t reliant on astronomical returns to drive your retirement, you can instead do the best thing possible: focus on keeping your expense ratios and taxes low through investing in index mutual funds. You’ll pay less in annual mutual fund expenses which helps raise your overall return as well.

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