The Difference a Percent Makes
Have you ever given much thought to the return on your investment portfolio? If not, you probably haven't considered the impact just one additional percent makes. Why do we think one percent isn't all that important? Because with many things, it's not. Say for example you're picking up a loaf of bread from your favorite supermarket and they've recently increased the price by one percent. Two weeks prior you paid $1.39 and now it will cost $1.40. No big deal. Barely noticeable. Here's another example. You traveled 500 miles in an automobile to visit family and on the way, fuel was $2.79 per gallon. You achieved 20 mpg so your total fuel cost was $69.75. On the way home, fuel costs have increased to $2.82 (a one percent increase). The trip home cost $70.50. You couldn't purchase a small coffee from McDonalds for the difference. Through experience we have been taught that 1% isn't significant. Cable bill goes up a percent, now worries. Health care premiums go up one percent, count your blessings! The annual gross domestic product (GDP) only increases one percent,the economy is nearing recession. An employer who gives one percent raises each year would have a tough time keeping employees. One percent isn't a big deal, unless we are talking about one additional percent compounding annually in your investment portfolio!
Consider this. Karen (age 62) has just retired from a local company after 30 years of service and has accumulated $500,000 in her retirement plan. Since Karen is no longer working, these assets will be needed to replace her employment paycheck. Her plan is to begin receiving $1,875.00 monthly from the retirement account for the first 5 years, then increase the amount for a cost of living adjustment. When Karen reaches age 67, the following scenarios are considered.
At 5% annual rate of return: Karen's account balance, after her monthly distributions, is $514,168.At 6% annual rate of return, her balance would be $543,606. That's an additional $29,438.
Because her living expenses have increased since she retired five years prior, she would like to increase her monthly distribution from $1,875 to $2,100 and continue this for the next five years.
Karen is now 72.
At 5% annual rate of return, Karen's account balance, after her monthly distributions, is $517,049.At 6% annual rate of return, her balance would be $586,725. That's an additional $69,677.As expected, her expenses have continued to increase. A sound financial plan should always factor the need for future increases in distributions due to inflation. Karen has determined that an increase to $2,400 per month would be sufficient for the next five years.
Karen is now 77.
At 5% annual rate of return, Karen's account balance, after her monthly distributions, is $500,345.At 6% annual rate of return, her balance would be $623,956. That's an additional $123,611. Karen's expenses have leveled out. She has traveled extensively since retiring 15 years earlier and while in good health she plans to still travel, just not as much as before. She has canceled her home phone service, reduced her cable bill by eliminating unwanted channels and prepares more meals at home. She will increase her distribution slightly, from $2,400 per month to $2,500.
Karen is now 82.
At 5% annual rate of return, Karen's account balance, after her monthly distributions, is $472,107.At 6% annual rate of return, her balance would be $667,198. That's an additional $195,091.
The scenario we've just reviewed demonstrates the power of just one additional percent, compounding annually over many years. It became significant (to the tune of nearly $200,000!). Karen is still in good health. She may once again increase her monthly distribution, she may keep it the same or maybe even reduce it. I think the point has been well made without the need to continue the comparison through Karen's full life expectancy. With an additional one percent annual rate of return, Karen has some desirable options. She can spend more money on her grandkids. She could gift more money to her kids and be around to watch them enjoy it. She could give more to her favorite charities. The options are available and meaningful.
A common misconception is the path to a higher rate of return is paved with higher risk or more volatility. This is assuming that both investment strategies are efficient in methodology and equal in expenses. My experience has been more often than not, this isn't the case. Investments strategies vary greatly. Some prioritize stock selection while others focus more on market timing. Neither have a strong track record on efficiency or consistency. When it comes to fees and expenses, again the gap between the available options is wide. Investment portfolios that closely track their respective benchmarks with relatively low investment expenses may need to add additional equity exposure and increase volatility to target a higher rate of return. There are many others, however, that could achieve this through strategy modifications.
It's only one percent and yes, it makes a difference!
