Why real returns are crucial for retirement planning
Interest rates can be expressed in two ways, as nominal rates or real rates. The difference is that the nominal rate of return is the percentage change, whereas the real rate of return is the percentage change adjusted for changes in prices due to inflation or other external factors. This keeps the purchasing power of a given amount of capital constant over time.
As an example, assume that you have £100,000 to purchase a new sports car. Instead of purchasing the car outright, you decide to invest the money for a year before buying in the hope that you will have a small cash cushion. If your portfolio earnt an interest of 4%, it would have a final value of £104,000. However, taking the inflation rate to be 2.3% (the 12-month CPI inflation rate from May 2018 in the UK), the sports car that you wanted to buy now costs £102,300. From this, your purchasing power has only increased by £1,700, or 1.7% of your initial investment of £100,000. This is your real rate of return.
When considering the real rate of return, savings plans with a guaranteed interest rate of 2% suddenly seem much less desirable. Your invested wealth is struggling to keep up with inflation, meaning that your purchasing power is decreasing each year. Although this is better than keeping the money as cash and is inherently low risk, your money is much better off invested so that your wealth can work for you.
With your wealth invested, risk timing is very important. If you are a long way from retirement a higher risk investment with the potential for a higher real return makes more sense, as you have the time to wait for your portfolio to reach its peak. As you approach retirement, it is advisable to take a more cautious or defensive approach to risk so that your real rate of return is smaller. This way, you are protecting your wealth to ensure that you have enough in retirement. Speak to a qualified advisor today, and make sure that your wealth is working effectively for you.