When Americans save, they often do so without a specific plan in mind. Sometimes saving is an afterthought – something that is done after all the bills are paid and extra income is enjoyed for current needs and wants. But the future is calling, and it’s begging you to save with more intention. Many people save without knowing the actual savings amount and rate of return necessary to reach a financial goal. Instead of arbitrarily picking a monthly savings rate for your future goals (think retirement and college education, for example), you should sit down with your advisor to calculate your Hurdle Rate of Return (HRR).
A Hurdle Rate of Return is like drawing a line in the sand. Will you meet your goal or not? Your HRR is calculated by considering your current savings and investments, along with projected rates of return, and probability of success. It can help you determine not only how much you should be saving, but also how aggressively you should be investing. The Hurdle Rate is the minimum rate of return you must achieve to meet your future income needs.
The classic Risk/Reward tradeoff assumes that if you invest aggressively, you will have potential for a higher rate of return, but will assume more risk of loss too. However, after an advisor works with you to calculate your unique HRR, it may be determined that you are taking more risk than necessary. Why take additional risk if you can already meet or exceed your HRR with a safer investment?
On the flipside, after considering your future income needs, you may realize that you should take more risk with your investable assets, or increase your savings rate to reach your goals. An earnings gap can be an eye-opener when it comes to the reality of your financial situation.
Let’s assume that you have set a Retirement Income Goal of $50,000/year and you need that income to last for a period of
30 years, adjusted annually for inflation. Your advisor can meet with you, and utilize sophisticated planning software to show you projections to determine whether or not your $50,000 goal is within reach. This is where the rubber meets the road – is your goal realistic? Do you need to ramp up your savings rate or take more risk? Do you need to pare back your spending now and/or in the future? Or, if you’re well on track, can you better protect your hard-earned assets by reducing risk, and maintaining a more moderate rate of return?
These are the questions you should be asking yourself and your advisor when you review your current savings plan and future income goals. Your advisor’s professional advice and financial planning tools can help set you on the right track. In conjunction with calculating your Hurdle Rate of Return, your advisor may reevaluate your existing investment portfolio. Your assets should include a diversified mix that allows for a rate of return that comes close to your HRR. When investing, past performance is not indicative of future results, but if your assets are allocated in a diversified manner, you will have some investments that perform well, while others underperform – creating a delicate balance that comprises your average rate of return. Investing is not an exact science, but planning with a professional can yield results that come close to your Hurdle Rate of Return.