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Monday, February 26, 2007

The 1.5% Real Return Estimate

Last night I had dinner with folks that included a couple who worked in the financial industry. As might be expected, the dinner conversation turned to financial planning, and what strategies are involved. The folks involved did private account management and financial planning, and as you might expect were quite financially sophisticated. I asked one of my favorite financial planning questions: if you needed $X in income over the next 60 years, how much in assets in a diversified portfolio (one that's close to the efficient frontier) would you need to be able to generate that much income in inflation adjusted terms?

Long time readers of my blog, of course, are well aware that the answer can be found on the retire early safe withdrawal spreadsheet. I wanted, however, to see what a conventional financial planner would say. The answer came out to be 150% of what the retire early number was. What was very interesting to me was that the number the planner used for the return from the average portfolio was described as a conservative 1.5% over inflation.

1.5% over inflation. Think about what that means. Current I-bond rates are at 1.4%. What that would mean is that the equity risk premium is only 0.1%. Can it really be that low? Even Warren Buffett, the pessimist, has been quoted as being able to expect a 4% real rate of return from businesses. So 1.5% seemed excessively conservative. Then I thought about the numbers from the conventional planner's perspective: the average cost of a separately managed account is approximately 1.5%. So that 4% real return now is really a 2.5% real return. Taxes can easily eat up another 1% of the remaining return, so now you're down to 1.5% real return.

So from an conventional financial planning perspective, the planner was absolutely correct! The lesson here, of course, is that paying someone else conventional financial planning fees is extremely costly, quite possibly costing you your retirement!. Which means that if you aren't doing your own financial management, you're really giving up half your real returns (to your financial planner, who probably blows 1/2 million a year flying private planes!).

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