It is only natural for investors to want assets with the best possible performance and lowest costs, but the secret to building wealth has less to do with returns and more to do with your savings rate, according to analysts at Pension Partners.
In other words, the amount of money you contribute to your retirement fund is far more important than what investment vehicles the money is parked in, as you can control the former but not the latter.
It makes sense intuitively. Saving $20,000 a year will grow your wealth a lot faster than saving $10,000 a year. But even incremental savings-rate increases play a far bigger role than corresponding increases in the rate of return.
To illustrate the importance of savings vis-à-vis investing, Charlie Bilello, director of research at Pension Partners LLC, ran some numbers on what would happen to your wealth if you increased your savings rate by 1% and correspondingly what would happen if the rate of return on a portfolio increased by 1%.
Bilello assumed a median U.S. household income of $58,000, which after taxes leaves $49,300 to spend. Saving only 1% of this income every year for 30 years at a 10% return will lead to an accumulation of $81,096. That number is less than your wealth after saving 5.5% of income at a meager 1%, which would grow to $94.319.
A 10% average return, while optimistic, does not seem outrageous, especially given that the S&P 500
has had a double-digit annual return on average over the past eight years.
But a 10% average annual return over the next decade is, indeed, optimistic, according to Blair Duquesnay, chief investment officer at ThirtyNorth Investments, a New Orleans–based independent registered adviser.
“The fact that we had large returns over the past eight years was to make up for a 40% drop in the stock market during the financial crisis of 2008,” Duquesnay said. “It is unlikely the next 10 years will look like the past 10 years.”
Duquesnay runs hypothetical scenarios with clients to show them long-term outcomes when choosing different rates of return versus increased levels of savings.
“A lot depends on when someone wants to retire and on what income. But the earlier you start saving, the better, because compounding happens in the second and third decade,” Duquesnay said.
Bilello acknowledged the challenges to saving for the future, which his said requires discipline and hard choices. Still, for those who are willing and able to save, research shows they have more control over their wealth than they think.
“Clearly, savings seems to trump investing returns for the average American household. This is good news, for saving more is something you actually can control, whereas earning a higher rate of return is infinitesimally more difficult,” Bilello said in a blog post.