Solid returns are our only hope

Let's run some numbers to illustrate how retirements live and die based on investment returns. Yes, saving, reducing debt and controlling expenses are important. But they merely get you in the game. The big swings hinge on average annual returns.

Retirement-saving success can be boiled down to a three-way formula: You can work longer, save more of what you make or earn more on your current investments. Asset allocation -- owning stocks, bonds or something else -- is the most critical part of that equation.

Let's work a quick example: Take a 30-year-old earning $60,000 a year who has no assets and wants to retire at age 65. If our example invests in corporate bonds offering a yield of 4.5% right now, that investor would need to save 41% of his or her income to reach $2 million at retirement -- a nonstarter for most. The percentage would be higher for an older investor or for someone trying to do it using bank savings accounts paying minimal interest.

But thankfully, we are in the midst of one of those rare moments when "safe" assets such as bonds are the "risky" ones -- in the sense they have become overbought, offer yields that don't compensate for inflation and risk, and have limited potential for gains.

At the same time, stocks are coming off of their worst run since the 1930s. In the years that followed the 1930s low, the S&P 500's 10-year total return peaked at nearly 600% in 1959. Meanwhile, bonds were ravaged after the Federal Reserve used negative interest rates (as we have now) to help the government cut its World War II debts by transferring wealth, by stealth, from savers to the Treasury.

Stock market investors, on the other hand, enjoyed an average annual return of 19.4% over the period. For the sake of illustration, that 19.4% return means a 30-year-old investor could save just 1% of his or her income and still have $2 million by age 65.

Obviously, this number represents the peak 10-year return; over the long term, don't bet on it.

What should you expect? Well, the S&P 500's average annual return on a total-return basis since 1800 is around 9%. For safety's sake, I'd dial that down to 7% or 8% when doing your retirement math.

The numbers aren't necessarily pleasant to look at. At 8%, that same 30-year-old worker would have to save 19.3% of his or her income every year to hit $2 million by 65. With a 7% return, the worker would have to save 24% of income; a 9% return would mean saving 15.4%.

What it takes to save $2 million by age 64 with $60,000 annual income
Starting ageAverage annual returnContribution as a % of income

I didn't say it was easy. I said it was possible. Particularly if you consider that you'll probably get a few raises over the years. But the bottom line is that your best chance -- maybe even your only chance -- to earn these returns is in stocks and stock funds.

Nikkei 225 average © MSN Money

Yet there's no guarantee that a period of underperformance will be followed by a period of strong performance. Just look at what happened in Japan, a country that's been dealing for decades with the structural problems we now face: an aging population, persistent government budget deficits, an out-of-control national debt, stagnant growth and flat wages.

Indeed, Japan's Nikkei 225 Average is now trading at levels first reached in 1983 and is down 53% from its 2007 peak and 78% from its 1990 record high.

What lies ahead

Investors, especially those who still believe in buy-and-hold or who lack the time to actively trade, will still need healthy amounts of diligence and care as the financial world moves ever closer toward one of the two outcomes I previewed in my earlier retirement column:

  • The stock market remains range-bound for another decade or more in a repeat of the 20-year stagnation of the 1960s through the 1980s, mimicking Japan's recent malaise.
  • Bonds end their multidecade rise on a combination of higher inflation, a workable solution to the global sovereign debt problems and corporate leveraging, providing the raw fuel needed for another secular, long-term bull market in stocks.

The second, of course, makes that $2 million 401k look much more possible. The first makes it very tough, requiring a much more active approach to investing. In any market, some stocks do go up -- but in a rangebound market, finding them is hard work.

But we'll have no choice but to do it, if retirement is to remain within reach.