Today’s investors may have drawn the proverbial “short straw.” From an investment perspective, they are confronting what might be considered a “perfect storm” creating strong head winds against higher expected returns. We’ll begin by discussing the three main factors conspiring against them, then analyze some of the options investors might employ to combat this problem.
Equity Valuations Are High
As I write this, the CAPE 10 on the S&P 500 is roughly 26.3. In a November 2012 paper, “An Old Friend: The Stock Market’s Shiller PE,” Cliff Asness of AQR Capital found that when the P/E 10 was above 25.1, the real return over the following 10 years averaged just 0.5%, virtually the same as the long-term real return on the risk-free benchmark, one-month Treasury bills.
The poor average returns—the best 10-year real return was 6.3%, while the worst 10-year real return was -6.1%—were a result of what might be called a “reversion to mean” for valuations.
That said, to estimate future returns using the CAPE 10 metric, you first calculate the earnings yield (E/P)—the inverse of the Shiller CAPE ratio—and get 3.8%. However, because the Shiller PE is based on lagged 10-year earnings, we need to make an adjustment because real earnings grow over the long term. I suggest using 2% as an estimate of future real earnings growth.
To make that adjustment, we multiply the 3.8% earnings yield by 1.1 (0.02 x 5), producing an estimated real return to stocks of about 4.2%, or a full 3 percentage points below the real return of 7.2% from 1926 through 2014. (We multiply by five because a 10-year average figure lags current earnings by five years.)
If we use the Federal Reserve Bank of Philadelphia’s Survey of Professional Economists forecast of 2% for future inflation, that produces an estimated nominal return of just 6.2%, 3.9 percentage points below the historical return of 10.1%.
Bond Yields Are Low
The Federal Reserve’s zero-interest-rate policy has driven both real and nominal yields down to historically very low levels. For example, since 1926, the real return on five-year Treasury bonds has been about 2.3%. As I write this, the nominal yield on the five-year Treasury is about 1.7%. Using the Federal Reserve Bank of Philadelphia’s inflation forecast produces an estimated real return of -0.3%.
Expected Portfolio Return
Using the above information, we can estimate the expected return for a typical portfolio allocated 60% to the S&P 500 Index and 40% to five-year Treasury notes to be just 2.4% ([60% x 4.2%] + [40% x -0.3%]). Again, add in estimated inflation of 2%, and we have a nominal return estimate of just 4.3% for this typical portfolio.
If you think this is bad news for individual investors, consider what it means for all the pension plans (both public and private) using assumptions more in the range of 7.5% to 8%. This clearly doesn’t bode very well either for taxpayers (who could be faced with higher taxes to make up for a shortfall in returns) and/or a pension plan’s beneficiaries (who might see benefit reductions).
Unfortunately, we aren’t done yet.
Life Expectancy Is Rising
Advances in medical science have led to dramatic increases in life expectancy. While that is clearly good news, it also means that investors must build portfolios able to sustain an acceptable standard of living for a significantly longer period. These are the ingredients of the perfect storm: much lower expected returns and significantly longer life expectancy.
They are, in short, the realities that today’s investors are faced with (and need to accept). As the saying goes, “It is what it is.” The question is: What can, and should, investors do to address this problem so they don’t run out of money halfway through retirement?
Fortunately, there are some steps you can take to help reduce the risk of this unthinkable event occurring. Let’s review them and determine which options are the good alternatives, which options are the bad alternatives and which are the truly ugly. The first four we’ll cover are the most effective actions you can take, and they have nothing to do with investing.
Differentiate Between Desires And Needs
The first, and most important, thing you can do is to make sure you don’t mentally or emotionally convert desires into needs. For example, buying a new car every three years (or taking a trip to Europe every year) may be a desire, but almost certainly it’s not a need.
In my view, if you can afford to do it, and it’s a priority for you, then you should do it because life is too short not to enjoy. What’s more, you cannot take the money with you. But the more you convert desires into needs (must-haves), the larger the portfolio you will require to sustain spending; thus, the more risk you’ll have to take. And that increases the odds of failure.
Fortunately, there are some other powerful levers you can employ to combat the perfect storm.
Extend Stay in Workforce
Every year you stay in the workforce will improve your odds of success. Not only will you be able to add to your financial nest egg, each additional year you work is one you’re not withdrawing from the portfolio. Even a part-time job will help, effectively reducing the amount you would otherwise need to withdraw from your financial assets.
Unfortunately, extending your working years isn’t always possible, because health issues can get in the way. That’s why disability insurance can play an important role in your overall financial plan.
Raise Your Saving Rate
Starting to save as early as possible and increasing your savings rate whenever possible can have a powerful effect, especially if you are early in the accumulation phase of your investment career. It’s often been said that compounding is the ninth wonder of the world.
We’ll now consider some of the investment strategies you can use to raise your expected returns. Unlike the ones we have considered so far, these next possibilities all entail taking more risk. However, they can be considered “good” options in the sense that the greater risks they entail have historically been compensated with higher returns.
However, you should consider taking these risks only if you have the ability, willingness and the need to do so, and fully understand the nature of the incremental risks involved.
Delay Taking Social Security Benefits Until Age 70
While the optimal age at which you should begin to take Social Security benefits involves many considerations—including your life expectancy, the age of your spouse, eligibility for Medicare and whether working longer can improve the level of your benefit—in general, delaying benefits will reduce your odds of running out of money.
Another consideration is that today’s low level of real interest rates means that, from an actuarial perspective, delaying benefits results in earning a significantly higher rate than you can earn on safe fixed-income investments.
And, importantly, by delaying benefits, you’re buying longevity insurance. Given the low level of real interest rates today, this means that you’re essentially being paid to buy insurance. When was the last time you were paid to buy insurance?
While a delay in taking benefits means you might have to draw on your portfolio earlier, the likelihood of running out of money early in retirement, even with earlier withdrawals, is lower than running out of money later with a higher benefit.
Monte Carlo Simulations
When running Monte Carlo analyses, we typically find that for investors with Monte Carlo simulation success rates in the 75-85% range, delaying benefits to age 70 improves the odds of retiring securely from 5-10%. We’ll discuss the use of Monte Carlo simulations in more detail later.
Next week, we’ll examine more of the investment-related steps that investors may consider taking to mitigate the factors contributing to this “perfect storm” and help ensure they don’t run out money in retirement.
This commentary originally appeared December 18 on ETF.com
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