A 12% retirement return assumption is ‘absolutely nuts,’ expert says. Here’s a realistic rate to expect

When you invest toward retirement, experts often like to say you are letting your money work for you. But how much can you realistically expect to earn on your money?

The annual rate of return — defined as the percentage change in an investment’s value — is an estimate of the gains you may earn over time.

Exactly how much you can expect to earn per year on average has been the subject of debate.

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A 25-year-old who invests $100 per month in an S&P 500 index fund in a Roth individual retirement account until they are 65 may see a 12% annual rate of return over 40 years, personal finance expert Suze Orman recently told The Wall Street Journal in an interview. Dave Ramsey has long called for a 12% return estimate in his calculations.

However, David Blanchett, managing director and head of retirement research at PGIM DC Solutions, is seeking to debunk the idea of 12% return assumptions. Among other reasons, that rate of return is “absolutely nuts” because it doesn’t incorporate volatility or inflation, Blanchett said.

He said a more reasonable return assumption is 5% for a balanced portfolio of stocks and bonds or 7% for a more aggressive exposure to stocks.

The point of the example was not to expect a 12% average rate of return on your money, Orman tells CNBC.com. Instead, it was intended to teach young investors what time and compounding can do, she said.

“You have no idea how many kids have said to me, ‘When I heard that I immediately opened a Roth IRA, I immediately started to put money in it,'” Orman said.

Young investors should start right now and should not wait, she said. The reason comes down to a concept called compound interest — that both the money you initially invest and the interest earned on that money will continue to grow.

Those investors start to learn that — no matter the return — it’s better to start at age 25 versus 35, she said.

“Every year that you wait, you have less time for your money to compound,” Orman said. “The less time you have for your money to compound, the less money you could have.”

Moreover, investing post-tax money Roth account versus a pre-tax traditional retirement account may help boost your returns, as tax rates may increase in the future.

Ramsey was not available for comment.

There’s a reason that 12% tends to be used as a benchmark, according to Blanchett. The average historical returns from 1926 to 2023 is 12.2%, according to a monthly data set called Stocks, Bonds, Bills and Inflation, or SBBI.

But that is based on a simple arithmetic return, which may not accurately reflect all fluctuations, according to Blanchett.

For example, if you have $100 and your portfolio goes up 100%, you now have $200. But if it then goes down 50%, that brings you back to $100. The average return, by taking the 100% and negative 50% returns and dividing by two, would be positive 25%. Yet your realized return would be 0%, as you are back to your original $100 balance, Blanchett said.

Another more complicated calculation used by experts, known as compounded or geometric returns, would better account for those fluctuations, he said.

“It’s just the impact of negative returns that hurt you so much,” Blanchett said.

So how much can you realistically expect to earn on your retirement investments?

“I would tell them 4% to 6%,” Orman said.

The two examples Orman cites have different returns for a reason, she said. The first example with a 12% average rate of return is to illustrate the power of compounding. The second lesson is to anticipate a conservative return, “because you never know what can happen in life,” Orman said.

Orman’s estimate is in line with Blanchett’s 5%.

Investors saving for retirement may see tools that provide return projections. However, it is important to be mindful how those anticipated rates of return are determined.

For example, Fidelity provides a balance projection for a NetBenefits accountholder’s next milestone age that anticipates a 3.5% return, among other assumptions. Because those time frames tend to be shorter, using historical returns is not necessarily the best strategy for those estimates, nor is it intended to be a long-term growth assumption, according to the firm.

To be sure, no rates of return are guaranteed.

Much of how much you may anticipate earning on your investments depends on your personal asset allocation, notes Brian Spinelli, a certified financial planner and co-chief investment officer at Halbert Hargrove Global Advisors in Long Beach, Calif., which was No. 8 on CNBC’s FA 100 list in 2023.

Investors in workplace retirement accounts typically have a limited menu of options from which to choose. If they opt for greater exposure to bonds or stable value funds, they can expect more muted returns compared to someone who is more heavily invested in stocks, Spinelli said.

The goal is to match those allocations to your time horizon, which typically means reducing the size of your stock investments the closer you get to your anticipated retirement date.

Generally, investors should not have major asset allocation shifts from month to month, quarter to quarter or even year to year, according to Spinelli.

It also helps to pay attention to the fees you may be charged on your investments, he noted. Fees eat into your returns.

To stay the course, it helps to anticipate a certain amount of volatility from the outset, he said. By selling and sitting on the sidelines and waiting for the market to recover, you may miss the market’s best performance days.

“In order to get those returns, you have to stay in it,” Spinelli said. “You cannot try to market time and try to get out and expect yourself to get back in at the lows, because [you] probably won’t make that decision.”