Assumed Rate of Return

The Assumed Rate of Return is the projected annual return on an investment or a portfolio of investments. Think of it as the financial equivalent of estimating your average speed on a long road trip; it's a crucial guess you need to make to plan your journey, but it's by no means a guarantee. This rate is a cornerstone of financial planning, used by everyone from giant pension funds managing billions to individual investors mapping out their retirement. For institutions, it determines how much they need to contribute today to meet future obligations, like paying pensions. For you, it helps answer the vital question: “How much do I need to save to reach my goals?” While essential for forecasting, this number is fraught with peril. An overly optimistic assumption can lead to serious underfunding and financial disappointment, while a conservative one provides a buffer against the market's inevitable bumps and detours.

The assumed rate of return is the engine of your financial plan. Change this single number, and your entire financial future looks different. If you assume a high rate of return (say, 12% per year), your retirement calculations will suggest you need to save relatively little. Conversely, a more modest assumption (like 6%) will demand you save more diligently to reach the same goal. The difference can be colossal over a lifetime of investing. This isn't just a personal finance puzzle; it has huge implications for society. Pension funds and insurance companies use an assumed rate of return to calculate their long-term liabilities. If they get it wrong—for example, by assuming an 8% return when markets only deliver 5% for a decade—they face a massive shortfall. This can lead to painful consequences like reduced benefits for retirees, higher contributions from current workers, or even taxpayer-funded bailouts. Your financial security, whether through a personal portfolio or a pension, hinges on this one crucial, and often subjective, number.

In the world of value investing, optimism is best served with a large dose of realism. The assumed rate of return is a primary area where wishful thinking can lead to disaster.

Many public and private pension funds have historically used high assumed rates of return, often in the 7-8% range. Why? A higher assumed return makes their financial health look better on paper and reduces the amount of money they (or their government/corporate sponsors) need to contribute each year. It’s a politically and financially convenient choice. The problem arises when reality doesn't cooperate. In a world of low interest rates and volatile stock markets, consistently achieving such high returns is a tall order. When the actual returns fall short of the assumed rate, a funding gap emerges and grows. To close this gap, the fund is often forced to:

• Take on more risk: Chasing higher returns by investing in riskier assets, which can backfire spectacularly.
• Increase contributions: Demanding more money from employees and employers.
• Cut benefits: Reducing payouts to future retirees, breaking a long-held promise.

You face the same trap, just on a smaller scale. It's tempting to plug a 10% or 12% return into a retirement calculator because it paints a rosy picture. It makes you feel like your goals are easily within reach. But what if your portfolio only earns 5% over the long haul? You will have saved far too little, and the time to correct the mistake may have run out. This is where the principle of conservatism is your best friend. Adopting a conservative assumed rate of return is a form of building a margin of safety directly into your financial plan. It forces you to save more and rely less on heroic market performance, making your financial future more secure and less dependent on chance.

So, what number should you use? There’s no magic answer, but a prudent approach is far better than a hopeful guess.

A common starting point is to look at long-term historical market returns. For example, the S&P 500, a broad index of large U.S. companies, has delivered an average annual return of around 10% over many decades. However, using this number blindly is a mistake.

• It's just an average: This figure hides decades of wild swings, including long periods of flat or negative returns.
• The past isn't the future: The economic conditions that produced those returns (e.g., falling interest rates, expanding globalization) may not repeat.
• It ignores inflation: A 10% return with 7% inflation is very different from a 10% return with 2% inflation. You care about your real return—the growth in your purchasing power.

A more robust method is to build a “bottoms-up” expectation based on current market valuations, not just past averages. A simple and effective way to think about this for a stock portfolio is: Expected Future Return ≈ Current Earnings Yield + Estimated Long-Term Growth Rate The Earnings Yield is the earnings per share of a company (or an entire index) divided by its price. It’s the inverse of the famous P/E ratio (E/P instead of P/E). It tells you what percentage return you would get if the company paid out all its profits to you as a shareholder. Today's earnings yield is a much more realistic starting point for future returns than a historical average. To this, you can add a conservative estimate for long-term earnings growth. Always remember to subtract the expected rate of inflation to find your real assumed rate of return. For example, if the market's earnings yield is 4% and you conservatively estimate long-term growth at 2%, your nominal expected return is 6%. If inflation is 3%, your real expected return is a more sobering 3%. Planning around 3-6% is far more prudent than planning around 10%.

The assumed rate of return is one of the most important numbers in your financial life. It is also one of the most deceptive. It is not a passive input from a historical chart; it is an active choice that reflects your investment philosophy. As a value investor, you should treat it with extreme caution. Reject the tempting, optimistic figures used in marketing materials and overly simplistic calculators. Instead, build your financial plan on a foundation of conservatism. By using a modest and well-reasoned assumed rate of return, you force yourself to rely on the one thing you can control—your savings rate—rather than the unpredictable whims of the market. It’s better to plan for a 5% return and get 7% than to plan for 10% and get 5%. The first scenario leads to a comfortable surprise; the second can lead to a retirement crisis.