Required Rate of Return

The required rate of return is one of the most important quantities in financial planning because it connects abstract goals to concrete portfolio decisions. Rather than asking what return a given portfolio historically achieved, the required rate of return asks a different question: given what we are trying to accomplish and what resources we have, what return do we need — and is that return realistic?

Calculating the required rate of return involves solving for the interest rate variable in a present value or future value equation. If an investor has $200,000 today, plans to contribute $15,000 per year for the next 25 years, and needs $2,000,000 at the end of that period, the required annual return can be solved for using the future value of an annuity formula combined with the future value of the lump sum. In this example, the required return is approximately 5.8% per year — a figure that can then be compared to the long-run expected return of a candidate asset allocation to assess whether the plan is feasible.

The required rate of return also communicates planning constraints clearly. If the required return is 3%, essentially any reasonable asset allocation can meet the goal, and the investor has wide latitude to hold conservative investments. If the required return is 9%, the investor faces a significant challenge: historical long-run U.S. equity returns have averaged approximately 10% nominally but with substantial volatility, and a portfolio requiring 9% returns must accept the sequence-of-returns risk that comes with high equity concentration. If the required return exceeds 10-12%, the goal is likely infeasible without increasing contributions, reducing the target, or extending the time horizon.

For retirees drawing down a portfolio rather than accumulating, the required rate of return is the return needed to sustain a given annual withdrawal for a target number of years without depleting the portfolio. This figure directly informs asset allocation in retirement: if a 3% real return sustains the withdrawal plan sustainably, the retiree can hold a conservative portfolio. If a 6% real return is required, a higher equity allocation is necessary — but so is careful attention to sequence-of-returns risk in the early retirement years.

The required rate of return is a diagnostic tool, not a prescription. It tells the investor what they need; the investment policy statement and asset allocation decision determine what they can realistically expect. When the gap between required return and expected return is large, the required actions are increasing savings, reducing spending targets, or accepting higher risk — not simply choosing a riskier portfolio and hoping for the best.