There's several risks that need to addressed when planning for retirement. One of the risks is assuming that if you earn a particular average rate of return on your investments in retirement that you will be ok. However, the order of the rates of return and the range of the returns can have a significant impact. The difference between average rate of return and the real rate of return is not often understood.
In this video I explain this simply, and even show how earning a lower average rate of return might mean more money could be available for you to spend in retirement. It all depends on the order and range of the returns that you earn that you achieve over time.
Full Transcript:
Hey, what's going on, everybody. It's Ryan here. Okay. So I got a question for you. Is it possible that earning a 4% average rate of return could actually be better than earning a 5% average rate of return?
Or let me take it one step further. Is it possible that earning a 3% average rate of return could actually be better than earning a 5% average rate of return?
So I'm going to answer exactly that in this video. But before I do, I want to share with you all a few key concepts, and I'm going to share with you. We're going to go through some spreadsheets, so if you don't like spreadsheets, I apologize up front. But I'm going to make this as fun and informative as I possibly can. So let me go and share my screen here with you.
Okay. So I want to start with this first because what I want to make sure that you really understand is the difference between average rate of return and the real rate of return, or the compound annual growth rate. So this is just a very simple example that we have here, or sequence of returns, that we have here to take a look at. And I want to ask you what the answers are as we go along here.
So the very first year, let's say that you have a initial account balance of a hundred thousand dollars. In the very first year you earn 50% on that money. Now I know these are really high rates of return that we're using, but it's going to make it so it's real easy math without having to get out a calculator. So if you earn 50% rate of return, and this is not a trick question, we're not assuming any taxes or any fees or anything like that. It's just straight 50%. How much do you have at that time? You've got 150,000, right? I heard you say it. I'm sure. So 150,000. Let's go ahead and plug that number in there.
Now the next year you lose 50%. How much do you have now? Now, if you said 75,000, you're correct. It's interesting because a lot of times ... I got to get that in blue there, there we go. So a lot of times, if I ask people that question, if you made 50% the first year and lose 50% the second year, without really thinking about it, a lot of people think that, well, I'm back to zero. But as you can see, that certainly is not the case. So let me ask you the question, and looking at this, what is the real rate of return after two years? Well, they lost 25%, right? You look at your statement after two years of being in this, and you're down to 75,000, you've lost 25 grand. You lost 25%.
Well, what is the average rate of return? Well, the average rate of return is zero. You made 50, you get lost 50%, so your average rate of return is actually zero. It's important to understand the difference here between average rate of return and the real rate of return, or again, the compound annual growth rate.
So let's go onto the next sheet here. Now, what I want to share with you here is this is a hypothetical example, and this blue line right down the middle of separating the left side from the right side. So what we're assuming on the left side is we're starting with $500,000. And actually, we're assuming that on the right side as well. And we're going to assume that our rate of return, that's the ROR, that we're earning exactly a 5% rate of return each and every year. Again, we're disregarding any taxes, fees, anything like that. It's just based on the actual, just the numbers, the 5%.
Now this side is earning 5% exactly every single year. On this side, we're earning 0% the first year, 10% the second year, and then that continues all the way through, all the way down to the bottom. And what I want you to see here is that on the left side, earning the 5% per year, after 30 years, as an example, they have 2,160,000 and change. Over here on the right side, even though this is the same average rate of return, right? They earn zero and 10, that's 10 divided by two is five. So the average rate of return is 5%. The compound annual growth rate is actually something less because you can see that their account balance is only 2,088,000 and change. Again, versus 2,160,000.
So what is that, that's 12, around $72,000, approximately, difference over that period of time. Just because of the variance of the range of returns that they have. Now, if these range of returns were even higher, then you're going to see this number right here, even lower. So in other words, if I did have this run so that it was, let's say minus 5%, and then a positive 15% on the other side, it would still average a 5% rate of return, average rate of return. But this number would actually even be even lower.
And what you can see now here is this is that same scenario. And what we're looking at is, the same 5% that we're earning on this side, and then on the right side we're earning the zero and then the 10, the zero and then the 10. And the only difference is now we're going to take a $30,000 withdrawal each year.
And now we want to take a look at what the impact would be. Because you've heard me talk about this before, but when you're withdrawing money from your portfolio in retirement, it's important to understand that the way that you invest, the way that you plan your withdrawals, and that's everything that you do in retirement, it's so much different. In other words, what I'm trying to say is that it's a big difference in how you plan in the accumulation years, up until you get to retirement, and then when you get into the decumulation years and you begin to start spending your money. Things start to work a little bit differently, and you can see that right here. Because what you'll see, if we go all the way down here to the bottom, is again, after 30 years, you're going to see that on this side, earning that consistent 5% rate of return, you still have $167,000.
On this side, you've only got about 86, almost $87,000, on that side. Okay. So it's a pretty big difference. Not overly significant. Let's look at year 20. Year 20 here, you have 334,000. And over here you have about 292,000. So not overly significant on that side. But let's go to the next one. Now what we're doing here is on the right side, the left side is staying the same, but on the right side, we've now introduced some negative rates of return into this, nothing huge, just the minus five. So it's a bigger range of returns that we're experiencing here. We've got a minus five and then a positive 15. And so the average rate of return, again, is 5% on both sides. The average rate of return is five. But the numbers at the end here are going to be very, very different. So if we go out to the bottom here, again, on the left side, you've got 167,000. By the 30th year here on the right side, it's actually going into the negative.
In year 29, it actually completely ran out of money. If we go, let's say year 20, as an example again. Over here with 334,000, and over here, we're at 219,000. So that's a difference of, what is that, about 120, almost 120,000, 115,000, at that period of time. Okay, so let's take it one more step. Now, let's look at what it would look like if they had a minus 10 and then a 20 each year, all the way through. Again, it's the same average rate of return. It's still the 5% average rate of return. But now let's look at what it looks like. Now, it's starting to look a lot worse. Okay. So what we're seeing here is, again, by the time they get to year 30, over here they would have had that 167,000 and change. Over here, they've been in the negative.
So you're not really going to go in the negative, that's just how I have my spreadsheet here working. Obviously it just means that you're out of money. You can see in year 24 there's only about $6,500 left and then they run out into the 25th year there. But if we look at, let's say the 20th year, year 20, they get 334,000 on the left side, versus only 123,000 over there on the right side. Okay. So it can definitely make a big difference depending upon the range of the returns, and the sequence of the range of returns, or sequence of the returns that you do get.
I put together another video just covering sequence risk, that if you haven't watched, I encourage you to go ahead and watch that as well, because that answers a lot of other types of questions that are important here.
Okay. So now let's do this. Remember our initial question? And I didn't prepare this spreadsheet, I was just thinking about this. But our initial question was, could have 4% average rate of return actually be better than a three ... I said, could a 4% average rate of return be better than a 5% average rate of return? Or maybe even could a 3% average rate of return be better than a 5% average rate of return? So let's take a look. I'm going to bring this down. Instead of it being five, I'm just going to make that a four. I'm going to bring this for all years here.
Take a look. So here we are. So year 20 on this side, we have 202,000 and change. Year 20 on this side, again, you only have 123,000. So in this case, by year 20, earning a 4% average rate of return is better than earning a 5% average rate of return. If we go down to year 30, definitely the better situation, it shows a negative number of a minus 60. Over here it'd be a minus 205. Really what happened here was year 28 you have $324 left. Where over here, year 24, you had about $6,500 left on that side. So definitely better. Yeah, the situation here on the left, even though it was only a 4% average rate of return.
So let's try three. I'm not even sure three will work in this case, but let's find out. I bet it will be close. And yeah. So there you go. Well, let's see, year 20. Okay. So year 20, you're actually a little bit less. By the time you get to year 20 you're at 96,000 versus 123. Year 30, you're at 200. You're at minus 213. Actually, by the time you get to year 30, it's almost about even. It's a minus 213 versus the minus 205. So very, very close.
I'm just going to do 3.5, just for fun, because now I'm curious. Let's see if that works in this situation. I bet it does. So yeah, there you go. So year 20, you have 146,000 versus 123,000. And you have better at year 30, a smaller negative number, then over here. So a three and a half percent average rate of return in this case is better than a 5% average rate of return. So it, it definitely, it depends on what the range of returns was from the left side versus the right side.
But why is this so important? Well, first off, most people don't even realize that this could be possible. That a lower average rate of return could actually be better than a higher average rate of return. But you've probably heard me talk if you've, well, maybe you have, maybe you haven't, but if you watch my other videos and such, I talk about different buckets of money. And sometimes I'll talk about buckets of money when it comes to taxes, meaning you want to have some money that's taxable, tax deferred, and then tax-free. But other buckets of money that I talk about have to do with short term, medium term and longer term.
So in other words, you're going to have certain monies may be set aside to handle short-term living expenses. Maybe for the next three, four, maybe five years. And then you have the second bucket for the more medium term. Maybe somewhere from three to four to five, up until 10 years, perhaps. And then you have the longer term bucket of money that's over here on this side, and that's really to cover your living expenses past 10 years.
So what happens is that shorter term bucket of money is typically invested more conservatively. Your medium term is more moderate, basically speaking. And then your longer term is going to be more aggressive to help keep up with the cost of living, keep up with inflation, or perhaps even potentially outpace inflation over time. So it's important to understand that, that we do that. And part of the reason that we do that is, especially on that longer term bucket of money, is that because we're not taking any withdrawals from that until, depending upon your specific plan or whatever we would do for you, because we're not taking any withdrawals from that, initially that's the longer term money, we don't need to be worried about sequence of returns risk with that money.
Instead, we can be more aggressive and know that we have the other buckets that are going to provide our living expenses in the shorter term. So obviously there's other sources of income and different things that could come into play, such as social security, pension and various other factors. But hopefully that kind of helps to understand why this is important to understand when constructing a retirement income plan and determining what assets are we going to use when, and how are we going to put all this together. So hopefully this all made sense. If it did, let me know, if it didn't, let me know that as well. I'm happy to address any questions that you may have. But hopefully you found it was helpful and I'll talk to you soon. Take care.