If you follow headlines in the financial press or read the blogs of various online “authorities,” you have no doubt bumped into many predictions that future investment returns from stocks and bonds are likely to be lower than historical averages. Here are a few from the past six months:
- “Preparing for Lower Returns…”
- “Pension Funds Brace for Lower Returns”
- “Are Low Stock Returns on the Horizon?”
- “Equity Returns Ain’t What They Used To Be”
Headlines like this present a scary prospect for newly retired investors counting on a portfolio of stocks and bonds to replace the predictable cash that previously came from a paycheck. Even retirees that have carefully analyzed their position using stress testing (Monte Carlo simulations, etc.) may doubt whether it is reasonable to assume that the past provides any insight regarding the future.
In actuality, historical stress testing, if understood properly, can provide very useful insight about how one’s retirement planning is impacted by the inevitable ups and downs of investment returns. Careful students of market history recognize that we’ve experienced periods of low investment returns in the financial markets before and, in some instances, these span long periods of time, such as a 25-year retirement.
Historical Returns – The Right Questions
We have fairly reliable historical data for the U.S. financial markets from 1926 through today, now a period comprising 90 years. Therefore, on just a straightforward historical basis, it is possible to look at 66 sequentially commenced 25-year-periods of investment returns to see what insight they provide. In examining this historical data, three relevant questions arise:
- What have the average returns been for investors living through retirement during these last 90 years?
- When examining a period representative of retirement (say, 25 years), how much fluctuation has occurred in average annual returns for these periods. What are the lows and highs?
- More importantly, have the “real” returns (above inflation) been sufficient to provide what retired investors want most: an inflation-protected “paycheck”?
What Does History Tell Us?
These are questions we regularly revisit in our ongoing Wealth Management Committee discussions. One technique we use is our historical simulation tool. Recently, we constructed a fairly typical retirement portfolio allocation: 60% U.S. equities and 40% bonds/cash. We used a mix of indices (Russell, S&P, Barclays) to construct this so we could go back in time and observe a retiree’s portfolio results over every 25-year holding period. In order to fairly simulate the actual experience of an individual retiree, we deducted 1.3% per year from the index returns to allow for investment advisory costs, although such an allowance is in many cases more than what might actually be required.
There are some interesting initial observations from a trip like this through the historical record:
- The average net compounded annual return (after all expenses) for all 66 of these 25-year-periods was 8.1% per year. This is the “nominal” return, before removing inflation.
- The highest nominal return was 12.8% per year (the 25-year bull market starting in 1975).
- The lowest nominal return was 4.2% per year (the 25-year period commencing the Great Depression in 1929).
At a first look, this makes two things evident. Extended periods of below-average investment returns have indeed occurred before. In fact, there were a total of 6 different 25-year periods where the average nominal return for a 60/40 portfolio was below 6% per year (5 of those 6 covered periods that overlapped significant portions of the Great Depression of the 1930’s). Without a doubt, an annual return of 4.2% is a far cry from the average annual return of 8.1% — in fact, barely half. Statistically, this difference in 25-year return between the low and the average can be evaluated by the standard deviation of 1.7% as being more than 2 standard deviations from the mean, which makes it potentially a painful outlier. Whether simplistically or statistically, that is a big enough difference to make any retiree pause and perhaps gulp.
The Other Half of the Story
These nominal historical investment returns, however, are only the first half of the equation when considering retirement cash flow security. The other half is inflation, since funding your spending needs must compensate for increases in your cost of living. There is a big difference between earning a 4% average annual return if your inflation rate averages 3%, compared to earning that same 4% during a time when inflation averages 1%. The same 4% annual return can do a lot more heavy lifting in the lower inflation environment, when it comes to covering your spending needs. Stated another way (in “wealth management” jargon), what matters most is your “real” return (or your return exceeding inflation) not just your nominal return. If most of the periods of lower nominal returns happen to be accompanied by lower average inflation, then the lower return itself is not nearly so great a threat to retirement security as one might fear.
Therefore, let’s light up the other half of the stage and look at inflation history. The average annual inflation rate for those same 66 distinct 25-year-periods was 3.6% per year. The highest inflation rate was 5.8% per year (occurring in two periods, both commencing in the mid 1960’s and working through the high inflation period of 1975-1983). The lowest inflation rate was 1.1% (the 25-year period starting in 1926 which includes some actual deflation in the early 1930’s).
So the actual question a retiring investor should be asking is “What is my expected real return, after inflation?” Again, it would be great to have a crystal ball, but since we don’t, let’s look at the historical record and draw some reasonable conclusions. Combining the 66 historical period returns with their corresponding inflation experiences reveals the following about real returns:
- The average annual real return was 4.52% per year. The highest real return was 8.13% (starting 1975) and the lowest real return was 1.28% (starting 1957).
- The spread between the lowest and highest real return is 6.85%, noticeably lower than the 8.6% difference when you look simply at the nominal investment returns. Statistically speaking, the standard deviation of real returns of 1.6% means that the worst return was about exactly 2 standard deviations from the average.
So What Is The Real Message?
The message in this data is one that while fundamentally recognized academically, is often overlooked when predicting that upcoming returns are likely to be on the lower end of the historical range: market returns reflect in part investors’ expectations for inflation. Many of these lower return periods, historically, were in fact accompanied by lower actual inflation. This means that the lower returns do not, per se, represent the threat to cash flow sustainability that might first be assumed.
Two Additional Postscripts…
Space does not permit extensive elaboration on two additional points but they deserve at least a mention, because they are relevant to this same issue.
1. Retired investors generally have to meet their spending needs on an after-tax basis. We live in an income tax system in the U.S. that is largely, but not fully, indexed to inflation. Periods of lower nominal returns, therefore, result in a reduced income tax drag. The practical result is that cash flow sustainability is relatively improved by the lessened tax burden.
2. The individual retiree’s individual circumstances of cash flow configuration will have a definite impact upon the specific impact of possible lower future returns in their own unique situation. The retiree who meets 65% of cash flow requirements from indexed Social Security is in a different position on the balance of his needs than the investor who meets only 20% from Social Security. This suggests that modeling and stress testing using various historical and Monte Carlo simulation tools is a worthwhile commitment by those addressing their retirement cash flow planning.
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Linscomb & Williams does not provide legal, tax or accounting advice. The information, analysis, and opinions expressed herein are for general and educational purposes only. This presentation may contain forward looking statements that may or may not occur. Nothing contained in this presentation is intended to constitute legal, tax, accounting, financial, or investment advice. Always consult with your independent attorney, tax advisor, and other professional advisors before changing or implementing any financial, tax or estate planning strategy.
Information expressed herein is based upon opinions and views of Linscomb & Williams and information obtained from third-party sources that Linscomb & Williams believes to be reliable, but Linscomb & Williams makes no representation or warranty with respect to the accuracy or completeness of such information. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice.
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