Rate of Return: Only Half the Formula

In this month's Financial Planning Magazine, Craig Israelsen noted a simple principle of investing that is often forgotten. Consider his example:

A 25-year-old earning $35,000 per year, who receives a 3% raise each year over the next 40 years, invests 10% of her income into a 401(k). This individual will have accumulated $275,000 by the time she retires assuming a 0% rate of return -- in other words, she will have contributed this amount over the 40 years. Thus, making contributions is the first engine of growth.

The second engine of growth is return. Assuming this individual achieved a 6% annual rate of return, she will have $880,000 when she retires. Clearly, returns are a critical element impacting the account value, but so are her contributions.

If this individual still achieves a 6% annual return, but only contributes 2% of her salary each year, after 40 years her balance would be only $176,000. To achieve an ending balance of $880,000 while only contributing 2% of her salary, the portfolio would need to generate an annualized return of 12.4%. Historical rate of returns illustrate that this type of return is not likely to be achieved over the long run. Thus, contributions to savings, not rate of return, is the primary factor necessary to help you reach your retirement goals.