Bert Whitehead, M.B.A., J.D. and Charles “Chip” Simon, CFP® © 2012
Can we realistically expect returns on our investments to be on a par with those enjoyed by past generations? Long-term historical stock market returns over a 20-year period in the U.S. have remained relatively stable at about 7-9% appreciation + 2% dividends over the past 80 years. When combined with intermediate bonds, a portfolio with 50% stocks and 50% bonds would reliably average a 7-8% return over a 20-year period.
However, the recent historic decline in interest rates has hurt total returns. Unless we see a marked increase in the stock market in the next 3-4 years, which would be a ‘reversion to the mean’, the 20-year historical average used for projections will have to be revised.
In this environment, near-term inflation is not likely to be much of a concern. The challenge will be to adapt to possible lower total portfolio returns.
There would be several sobering results from this economic revision. One is that clients will either need to work longer to accumulate a larger investment retirement portfolio, or they will have to plan to downsize. This is particularly true for the ‘echo-boom’ generations born in the late 1960's and later. They are not likely to have reliable social security benefits, and guaranteed pension benefits are becoming a relic of the past.
It’s also likely that children will not inherit as much wealth from their parents, as parents will use up those assets in their old age. Our youth will be paying a high price for increasing life expectancy.
To round out this scenario, we have to remember that governments are inclined to rescue every segment of society by increasing the money supply. Printing more money is a long-term inflationary strategy that is likely to compound the financial stress on at least the next two generations.
There is no easy way out of this if the economic duress continues and is exacerbated by public resistance to austerity. As a result, it becomes imperative that we teach our children these important basics to survive in the new reality:
1) Each family must produce more than they consume.
2) Our futures depend on saving at least 10% of our earnings through our lifetime to support us in old age.
3) Future citizens will have to recognize that life expectancy will determine their retirement age.
Now you might be nodding your head and saying 'ain't it awful!' with like-minded friends. But if you present these three points to your grandparents they are likely to look at you and say “DUH!” Wasn’t it commonplace for families to lead productive lives? Wasn’t it known that living below your means rather than beyond your means was bound to put you on a better financial firmament? And weren’t pensions originally keyed to life expectancies? (Yes, even in the late 1800s in Bismarck’s Germany)
The point is that the important changes have to be ‘endogenous’ and start with the factors we control in our lives. We can’t really wait for our lives to be dictated by ‘exogenous’ changes, whether they be Republican, Democrat, policy-based, Supreme Court sanctioned or anything else beyond our immediate control.
What can you do now? We don't advise immediate and precipitous portfolio revamping. Retired clients who have experienced the benefits of completed bond ladders already know that they are well protected financially for the next 15-20 years.
For clients who are still accumulating assets and building their bond ladders, a reduction in the total portfolio return will likely have an impact on retirement planning. During regular investment review appointments, we have generally calculated 'market rate of return' at 7 -8%. We are now also looking at the impact if rates of return fall to 5-6% (assuming a portfolio of 50% interest earning and 50% stocks). Finally, we urge clients to remember that it is a mistake to take more portfolio risk to offset the decline in market rates of return.
I am not predicting the future will unfold as outlined above. There are likely many countervailing developments, many of which will be positive.
But I do think that there is a new reality that has been set in motion that is not going to be reversed in the next generation or two. Most of it is based on modern longevity and will require a change in financial expectations.
But remember your grandparents and ignore the basics at your peril. While there are some long-term possibilities that we should consider in our decision making today (like less Social Security for the young), we can only fruitfully focus on the three issues above that are in our control. I am comfortable thinking that the actions needed to adapt to the ‘new’ investment reality will have a very familiar sound.