A 12% retirement return assumption is ‘absolutely nuts,’ expert says. Here’s a realistic rate to expect

When you invest toward retirement, experts often like to say you are letting your money work for you. But how much can you realistically expect to earn on your money?

The annual rate of return — defined as the percentage change in an investment’s value — is an estimate of the gains you may earn over time.

Exactly how much you can expect to earn per year on average has been the subject of debate.

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A 25-year-old who invests $100 per month in an S&P 500 index fund in a Roth individual retirement account until they are 65 may see a 12% annual rate of return over 40 years, personal finance expert Suze Orman recently told The Wall Street Journal in an interview. Dave Ramsey has long called for a 12% return estimate in his calculations.

However, David Blanchett, managing director and head of retirement research at PGIM DC Solutions, is seeking to debunk the idea of 12% return assumptions. Among other reasons, that rate of return is “absolutely nuts” because it doesn’t incorporate volatility or inflation, Blanchett said.

He said a more reasonable return assumption is 5% for a balanced portfolio of stocks and bonds or 7% for a more aggressive exposure to stocks.

The point of her example was not to expect a 12% average rate of return on your money, Orman told CNBC.com. Instead, it was intended to teach young investors what time and compounding can do, she said.

“You have no idea how many kids have said to me, ‘When I heard that I immediately opened a Roth IRA, I immediately started to put money in it,'” Orman said.

Young investors should start right now and should not wait, she said. The reason comes down to a concept called compound interest — that both the money you initially invest and the interest earned on that money will continue…