Making Different Choices Due To Low Expected Returns

Wade Pfau, PhD, CFA

Wade Pfau, PhD, CFA

In  a recent blog post, Wade Pfau argues that investors with a moderate portfolio should be expecting returns going forward to be around 2% real.  Whether or not you believe his methods, the problem with a 2% return is that it takes an entire career for your money to double at that rate.  That’s simply not acceptable for any type of reasonable retirement planning for most Americans.  If returns are really going to be that low, it changes the game completely.

Pfau May Be Too Negative

I run most of my retirement projections off a number that I used to think was fairly conservative – 5% real.  I’m not so sure anymore, especially given historically low bond yields (most of which are negative in real terms.)  It’s just hard to average 0% or less with anything and get a decent return over the long run.  Even if stocks achieved their historically average returns (8.6% real according to Pfau) you’re not going to get 5% with a 50/50 portfolio.  However, I think Pfau is probably a bit too negative.  Exhibit A?  My own returns.  As regular readers know, I have tracked my own returns meticulously from the day I started investing, March 11th, 2004.  Through both the 2008 crash and the ensuing 4 year bull market, I have achieved an accurate XIRRed, geometric, annualized return of 7.54% per year.  In March 2004 the CPI-U was 187.4 and today it is 230.3.  That annualizes to 2.33%.  7.54% – 2.33% = 5.21% real.  So I’m meeting my projection over my first decade of investing.  At 5%, my money doubles every 14 years, which is much better than every 36 years at 2%.  Of course, I’m carrying what many consider to be a young man’s asset allocation, 75% stocks with lots of asset classes considered riskier than US Large Cap Stocks.  Using today’s conventional wisdom, carrying that type of portfolio into retirement is a bit foolhardy.

Wade’s projections may be overly conservative for another simple reason- investors won’t stand for it over the long run.  They’ll take their money out of the stock and bond markets and invest it somewhere else if they’re not paid adequately for running those risks. Once enough money leaves the markets, yields and expected returns will rise to levels adequate for a reasonable retirement plan.  Of course, there’s no evidence of this happening yet.

2% Real Is A Game-Changer


If returns really are 2% real (and don’t get me wrong, they are for many Americans already due to inadequate asset allocation, behavioral mistakes, and high investing costs), that’s really a game changer.  At a certain level of return, investing in a portfolio of stocks and bonds simply wouldn’t be worth it.  It would be time to consider some alternatives.  Let’s look at some of them.

Working Into Retirement

Many Americans have found they need to work well into their golden years to have the retirement they want.  This is often due to inadequate savings rates, a poorly thought-out investing plan, or even the loss of an expected pension.  But if your money isn’t really growing anyway, it may be easier to live on earned income in retirement instead of portfolio income.  Just half of my current income is more than enough for me to have a very comfortable retirement.  Add in social security and I could probably easily live on what I’d earn working 1/4 time without any significant savings at all.  The problem with this approach, of course, is that some people won’t be able to keep working very far at all into retirement.  I’m also well-aware that many professionals are not like emergency docs- they can’t just cut their shifts back at will.  It’s either work full-time or don’t work at all.

Real Estate Investing

Investing in real estate is much more like a second job than investing in paper assets like stocks and bonds (especially when using an easily managed portfolio of index funds.)  But it traditionally has had returns very similar to the stock market.  There are lots of risks, but most of them involve leverage, and it isn’t that hard to decrease leverage as you approach retirement to minimize that.  If I really thought my portfolio was only going to earn 2% real going forward, this is probably the first place I’d go to find the returns I need/want.  Thousands, perhaps millions, of people have retired off the income from their investment properties.

Investing In Small Businesses

Along the same lines, when paper assets aren’t making much, buying a Chic-Fil-A franchise or a dry cleaner business or a roofing business etc starts looking more attractive.  If I can get a return on my capital of 8% real in a small business, but only 2% real in my portfolio, I’m probably willing to put in that effort and take that risk.

Take More Investment Risk

As yields on fixed income have fallen, this is an approach I have looked at more and more.  Of course, it’s wise to remember that more money has been lost chasing yields than in the stock market, but I find it difficult to invest money at 0.02% (the going rate in money market accounts), in moderate length treasuries paying less than the inflation rate, and in TIPS with negative real yields.  The current environment punishes savers and conservative investors, and seems to reward spenders, debtors, and investors willing to take risks.  “Why fight it?” you might wonder.  There are lots of ways to take risks and increase EXPECTED returns.  Instead of investing mostly in US large caps you can invest in small caps, value stocks, microcaps, emerging market stocks or REITs.  Instead of investing in cash, you can invest in precious metals.  Instead of investing in relatively safe, short-term bonds, you can invest in long-term treasuries, corporate bonds, or Peer to Peer Lending.  When making an extra 1-2% on your portfolio is the difference between 2% real and 4% real, some of those risks seem more worthy of consideration to me. In fact, in many ways I’m already doing this with a sliced and diced portfolio and perhaps that’s why I haven’t had 2% real returns over the last decade.

Don’t Invest At All


With anemic interest rates, some may wonder whether to invest at all.  Why not live it up now, spend your whole paycheck, and then just plan on a much decreased standard of living in retirement?  Traditionally, investing is about whether you’d like to spend $100 now or $300 later.  As rates come down the question becomes “$100 now or $100 later?”  At negative real rates, that choice could become “$100 now or $50 later?”  At a certain point for everyone, there’s little reason for saving for the future.

Guaranteed Investing Options

The main problem with investing in insurance products like cash value insurance or annuities is that after all the expenses, you end up with low returns.  But if market returns are so low, then these guaranteed, but low, returns don’t look so bad.  I recently calculated that the cash value for a whole life insurance policy bought today and held to your life expectancy, had a guaranteed return of 2% (nominal, not real) and a projected return of 4-5%.  Obviously if the markets have poor returns, the returns in the insurance product are going to be much closer to 2% than 4%, and theoretically the company could even go out of business, but even the most ardent whole life insurance foe has to admit that, at a certain point, the guarantee is worth something.

Gamble

If expected long-term returns are low, it increases the incentive to gamble, whether that involves putting it all on red, buying a lottery ticket, or just taking up the habit of market-timing/short-term trading.  If the chances of you reaching your retirement goals are only 10% due to low expected returns, then perhaps the 48% chance achieved on the roulette table isn’t so bad.

Now I’m not making any significant changes to my portfolio based on our low interest rate environment or these rather pessimistic projections of future returns that I’m seeing out there.  This is mostly just a mental exercise.  I’m certainly not recommending you abandon principles that have worked for investors for decades (perhaps even centuries.)  But every now and then, it’s fun to think outside the box, even if you don’t actually ever leave it.  I do, however, recommend you track your returns over time and adjust your savings rate, the length of your career, and your projected retirement lifestyle accordingly.

If you knew your portfolio returns over your lifetime were going to be 2% after inflation, what changes would you make in your lifestyle and investment strategy?  Comment below!

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Comments

Making Different Choices Due To Low Expected Returns — 19 Comments

  1. I see you started in 2004. Now, do your analysis as if you started investing in 2000. You real return will be close to 0. You are right, nominally the stock market return is 8.4%.

    I think what people have to do is analyze how their investments are doing before figuring out when they will retire. If you lose one year, maybe you should do more overtime to invest in cheaper stock.

    One thought I did have which is against conventional wisdom is to initially invest in the highest yielding safest investments first, then later on go for broke. But have a floor, and use an immediate annuity as the backup plan if you hit your floor. This gives you some guarantee.

    • You can obviously change results by changing the period over which you calculate them. Why start in 2000 instead of 1995 if you’re going to back-test? Or 1929? Instead, I just used when I actually started.

      I agree that a great option for someone who doesn’t have enough to retire is to delay retirement a few years.

      Zvi Bodie advocates your idea to have a floor of safe investments, both in the accumulation phase and the distribution phase, then invest in riskier asset classes above and beyond that. The problem with that approach is that you have to do all the heavy lifting to get to your minimum goal, and you can’t count on your portfolio doing any of it. For example, if you wanted to build a portfolio solely composed of short term TIPS, you’d find that you’re actually LOSING money each year after inflation, taxes, and expenses. That means you have to save more than you’ll ever spend in the future, requiring a ridiculously high savings rate. It just doesn’t work for most people. I’d say my savings rate of 20-30% is higher than 99% of Americans and I simply need my portfolio to do more of the lifting to reach my reasonable goals.

      I do like immediate annuities for a portion of retirement assets in the withdrawal stage.

  2. Good analysis but none of the alternatives are open to many people. The only other alternative is one that I use. Have a large enough retirement investment that you can live off the income from it. This means at least 2M in investments and a somewhat frugal life.

    • Confused. You mention that most of those alternatives are not open to most people and then suggest one that is less open than all of them….

      • I agree. Which ones aren’t open? If you have the money to invest in stocks/bonds, you have the money to invest in small businesses and real estate. Sure, some people can’t work into retirement, but anyone can change their investments.

        • Working into retirement is not an option for some. Either their job is physically demanding or they have other impediments from working past their full retirement age.

          Investing in real estate (directly) can require personal involvement in the identification and approval of tenants, dealing with them and the maintenance on the property.

          Investing in Small Business can be very risky and if you are an owner can take up a lot of your time and energy.

          The other alternatives are available. Sorry for the confusion.

  3. Nice article. One thing investors should think about is what are the various goals of investing. There are two ways to make money in the market, either through capital gains when stocks go up in price, or through cash flow.

    There are a number of cash flow opportunities that would provide indefinite income for retirement. Instead of putting money into low yielding bonds you could use that money to purchase high yield dividend paying stocks or find those companies that are increasing their dividend yield annually. For example, “During the past 50 years, JNJ has never increased the annual dividend yield by less than 5.9%.” (Source: http://seekingalpha.com/article/878361-3-stocks-that-raise-dividends-every-year) There a number of companies like this that offer a much larger and safer return on your investment than bonds. J&J is not Lehman Brothers, they are never going out of business and people will always use the products they make.

    The only risk here is that you could lose money on your initial investment but if you are a retiree you don’t really care about that. It is like buying real estate. If you buy a property and it goes down by $20,000, if you are investing for cash flow it doesn’t matter because your goal is not to flip the property or sell it. You know that every month you will be getting a check and that is your goal, to increase your cash flow. If fact, you probably should never sell it so that you never have to pay the capital gains tax on the sale of the property and if you have a smart estate planner you can give it to your heirs and they don’t have to pay the tax on it when you die.

    Another option is to use high-yielding REITs which are excellent cash flow investments. For those that don’t know a REIT (real estate investment trust) is a publicly traded company that owns and operates real estate investments. They have preferred tax status if they distribute at least 90% of what they earn to investors. One that I can think off the top of my head is AGNC (American Capital Agency Corporation) which currently has a yield around 15%. Just like with dividend stocks you could lose money on your initial investment if the stock goes down but if your goal is cash flow it may not be as important to you, especially if you are of retirement age.

    From a retirement perspective, cash flow is much more advantageous than living of stock market gains. As long as your monthly cash flow exceeds your monthly spending habits in retirement, you are indefinitely wealthy. If the market enters a bear market that doesn’t concern you, all you know is that you are generating enough cash flow to live comfortably off of.

    If you are close to retirement age, bonds are a terrible place to park your money for two reasons. 1) As Jim mentioned in the article low bond yields punish savers and conservative investors so you are getting no return on your money. 2) All the govt. intervention has pushed bonds prices to historically high levels and a lot of people are going to be hurt when prices come back down. Just because you are in bonds doesn’t mean you can’t lose money.

    Felix

    • I think you’re making the classic mistake of not being a total return investor. You don’t get to (or have to) choose between gains and income. They are generally readily convertible from one form to another, particularly within a retirement account. If you have two stocks whose total return is 10%, and one has a 10% yield and the other has a 0% yield, you can use them to support the same income level. In fact, if you’re in a taxable account and the capital gains tax rate is less than the dividend tax rate, you’re better off with capital gains than dividend income.

      Don’t assume that because a stock has always increased its dividend rate that it will do so in the future. Also don’t assume it’s value cannot fall. What good is it really to have a 5% dividend increase to 8% when the value of the principal the dividend is calculated on falls by 50%? You may think J&J can’t ever disappear, but many people said the same thing about Enron, Worldcom, and almost all of the original DJIA stocks. Good companies do go out of business. REITs are also hardly a risk-free income play. Vanguard’s REIT Index Fund fell 75% in the recent bear market. Stocks, including REITs, don’t have 15% yields unless there is serious risk of loss of principal. A bond yielding 3% and a stock yielding 3% are not the same thing and shouldn’t be mistaken for one another. Besides, in an economic downturn dividends get cut all the time. They’re hardly set. In 2008, 288 companies cut dividends. In 2009, 804 more did.

      If a company is making money, it’s stock holders will be rewarded with increasing capital gains and/or solid dividends. If the company is losing money, the investors aren’t going to somehow make money because they bought it for the dividend. It doesn’t pass the sniff test.

      Bond investors are getting hurt because yields are lower than inflation, not because they’re going to lose a lot of principal. Total bond market duration is 5.3 years, so even if interest rates go up 2% this year, an investor is only going to lose 10.6% of his investment, hardly a blood bath. It’ll take 5.3 years to make up for the loss with higher yields, and after that he’ll be better off with the higher yields. I fear that many of the investors who are chasing yield by investing money in REITs and dividend stocks that should be in bonds are going to be hurt in the next stock market down turn. More likely, they’ll just be whipsawed as they chase performance.

  4. Hi Jim,

    I agree with your point of being a total return investor but my discussion pertained to bonds since that was what your original post was about.

    Your comments about the risk of REITs going down is valid and I discussed this in my post. Nothing takes the place of risk management whether you are buying REITs or stocks in general. If we get a significant market downturn, REITS and stocks will both go down, there is no safe investment in a bear market.

    Yes, companies that lose money do cut their dividend but you can find companies out there that are much more stable. The following chart shows the dividend history for JNJ, they have increased their dividend steadily every year since 1997 including 2008 and 2009. It does not have to be all or nothing, bonds or no bonds. But if bonds make up a significant portion of ones portfolio I would diversify into other low risk assets such as high yield dividend paying stocks in stable industries that generate good cash flow and have a trend of increasing dividends.

    I would disagree that bond investors are not going to get hurt. You are saying that total bond market duration is 5.3 years but do you know the duration of the bonds being held in your bond portfolio? Maybe you do but I can guarantee that 99% of people don’t. What if your bond fund is holding all 20 and 30 year treasuries, if interest rates go up even by just 1 or 2% these people are going to get crushed. If your fund is only holding 1 or 2 year bonds you may be o.k. but why would anyone invest in these short term instruments when the yields on 2 year notes is only 0.24%, this would be crazy.

    Like you said, you need to take your whole portfolio into account and my posts only pertain to the bond allocation. One thing I think I can say with relative certainty is that eventually interest rates are going to go back up. There is no point in trying to guess when this will occur because that is impossible but at some point, whether it be 5 or 10 years from, interest rates will rise again. If people have bonds funds, they better check to see the maturities of their bonds holdings because they are at very significant risk. And if you are older with the majority of your portfolio in bonds, I would urge these people to check this sooner rather than later.

    As always Jim, nice discussion.

    Felix

    • It isn’t crazy to invest only in 1-2 year bonds. While you don’t get much income, you do get to moderate the risk you’re taking on the equity side (where it is more efficient to take it). Bernstein argued in an article today for treasury bills despite zero yield:

      http://www.indexuniverse.com/hot-topics/16379-bill-bernstein-make-peace-with-t-bills.html?showall=&fullart=1&start=2

      I agree it doesn’t have to be all or nothing.

      My bond portfolio contains the TSP G fund (duration is zero), the Schwab TIPS ETF (duration is 8.16 years), and some P2P lending with maturities of 5 years or less (don’t know the exact duration, but it’s certainly less than 5 years and interest rate risk is minimal compared to the credit risk). It took almost 20 seconds to look that stuff up. There’s no excuse for any bond investor not to know the approximate duration of his investments. If your sole bond holding is Vanguard’s Long-term bond index fund with a duration of 14.7 years, then a 1% increase in long-term rates would result in a 14.7% loss. While that would be a bummer, it’s hardly “getting crushed,” especially given the now 1% higher yield on the investment. Getting crushed is losing 75% of your REIT holding and then having the yield stay the same or even fall.

      You say with relative certainty that eventually interest rates are going to go back up. I propose that you don’t actually know that, nor do you know when that is going to happen. You may be right that they’re going up, but they might not go up for 50 years. Investing like they’re about to go up for 50 years waiting for it to happen will hurt your returns. Most investors thought rates had nowhere to go but up 3-4 years ago and if anything, they’ve gone down. Take a look at Japanese bond interest rates for the last 20 years. Who’s to say that isn’t in store for US bond interest rates? You just don’t know and remembering that when choosing investments is important.

      Anyway, my point is that stocks aren’t bonds, even those that appear to be lower risk, and I’m sure you agree with that. You say “you can find companies out there that ARE much more stable.” I think you misphrased that. You meant to say “you can find companies out there that HAVE BEEN much more stable.” Assuming the past will persist into the future is a classic investment error and leads to performance chasing. You take the past into account, of course, but always remembering the government-mandated words printed in every prospectus- Past performance is no guarantee of future performance. J&J isn’t a penny stock by any means, but it isn’t a treasury bond either.

  5. WCI,
    While I agree that 2% is awfully low, I’m not confident that many investors will be able to or are actually choosing many other investments. If anything, the Fed’s ZIRP has actually forced many more savers into equities. I think part of this current upswing is due to many older investors chasing yields and returns in the stock market. I agree with Barry that many 70 year olds may not be interested in the real-estate/small business/other arena, but there are plenty that will. Real estate can be hands off depending on the location. Smaller towns in Oklahoma are easy here because you can drive to the place 15 minutes away and you know most all the repairmen, etc. And rent houses can be bought for well under 100k in many places (even metro OKC). 2% won’t hold for 30, 40, or 50 years, but i think it’s likely a 5 or 10 year result could occur at 2-3%. $2M at a 4% withdrawal is $80k, which is way more than i live on now and ideally I’ll have my mortgage paid off by retirement. I think 80-100k is a pretty comfortable retirement depending on age and how much traveling you wanted to do.

    Also, do you think CPI represents true inflation or is it held down?

    • I discussed this in a comments section somewhere else. The reality is that inflation is personal. If you spend a lot on colleges and health care, you’ve had far more personal inflation than the CPI. If you spend your money on computers and TVs, then you’ve had a lot less. It doesn’t really matter what the government says it is. What are you going to do about it if they’re understating inflation by 1%? If you believe they’re understating it by 8%, then you’d best start buying up a lot of gold and real estate using fixed rate loans. If you really want to know what YOUR inflation is, then keep track of it. Gas, food, rent vs mortgage etc. In the summer of 2008 gas was $4.12 a gallon. Now it is $3.62. Does that sound like 8% inflation to you? In 2009, the average monthly grocery bill for a family of 4 was $942.50. In 2012 it was $1025.30. That’s around 2.9% inflation. An iphone 4 used to be $600. Now it’s $450. Homes that sold for $250K in Las Vegas are now going for $75K. This idea that the government is somehow hiding inflation of 5-10% or more just doesn’t pass the sniff test. The market is smarter than any of the rest of us. It estimates that inflation as measured by the CPI over the next 10 years will be 1.86% – (-0.65%) = 2.51% (nominal 10 year minus the 10 year TIPS). Your personal rate of inflation may be more or less than that, but it’s unlikely to be a lot more than that unless you’re paying for a lot of health care or college tuition or other items whose rate of inflation is far higher than the general rate of inflation.

  6. Absolutely agree WCI, I just wanted to see your take on it before prejudicing you to any side. The things i’m buying (mortgage, car insurance, health insurance, food) haven’t really jumped up 10% (I’d notice). My house insurance did jumps 20% but it amounts to $20 a month and OK had two bad tornado seasons in a row. Tuition has jumped, but I offset that by choosing a state school. Thanks!

  7. William Bernstein seems to be even more conservative at this point than Wade Pfau, whom I also respect. From a recent interview, he is expecting 1% real returns on a 50/50 portfolio (using short term bonds, which he advocates). He is expecting 3% real returns on equities, which would be about 5% nominal at this point. I am not one to bet again Bernstein.

    http://www.indexuniverse.com/hot-topics/16379-bill-bernstein-make-peace-with-t-bills.html?showall=&fullart=1&start=2

  8. I am surprised that responders to this thread are still expressing some very common yet outdated misconceptions about investing in real estate: for example, that it has to be a “second job”, that you have to live “15 minutes away and know the local repair men” and be available to fix toilets or leaks, or that “investing in real estate (directly) can require personal involvement in the identification and approval of tenants, dealing with them and the maintenance on the property.”

    I and many others can tell you from personal experience that this doesn’t have to be the case.

    Absolutely it doesn’t, but what you cannot do your self you must pay someone else to do and the price you get on those things directly affects your return. Case in point, I paid someone recently $700 to do repairs on my property across the country. I could have done them myself in a couple of hours. Even if you don’t want to do repairs yourself, it’s much easier when you can go by and decide what does and doesn’t need repairing/replacing than when you have to trust someone else to make that decision.

    But it’s logical to think that if you’re going to amass any kind of significant real estate “empire”, you’re not going to be doing your own repairs and management if you’re holding down a job as a doctor.

  9. Doctor K is absolutely right about investing in Real Estate. Passive, fractional ownership can get you into multimillion dollar deals with a similar investment as you would make yourself putting 30% down on a 4plex in many markets. Except, you don’t have to manage tenants and toilets and you get the economies of scale that allow for predictable income which is hard to find with residential real estate.

    REIT’s can be a good investment, but make no mistake it is a paper asset. They follow the economic cycles more closely than multifamily which more closely follows population cycles. Also, as Felix pointed out, the REIT has preferred tax status, not the individual investor. In fact, tax savings is a great benefit of real estate for the individual investor. Those benefits all go away when you purchase a REIT as opposed to physical property.

  10. Lastly, the statement was made that most of the risk with real estate revolves around leverage. It is true that you can reduce risk by deleveraging (paying down the loan or increasing the value of the property). However, deleveraging also decreases your return on investment. A better way, in my opinion, to decrease leverage risk is to only invest using non-recourse lending. Non-recourse lending limits your risk of loss to your initial capital investment and nothing more.

    Take an example of a $5 million property you fractionally invested in using $50K or your own money you pooled with like-minded investors using non-recourse lending. Now contrast that with a $200,000 4plex you purchased by yourself with $50K down using a recourse loan. Lets say they both burn down and you failed to purchase insurance to cover it. Highly unlikely, I know, but anyway, you lost your $50K on both deals. You are not out anything else on the non-recourse deal, but the bank can come after you for the other $150,000 with the recourse loan.

    • Non-recourse lending is wonderful when you can get it.

      It’s still not entirely clear to me where a know-nothing goes to get involved in these “fractional ownership deals.” It seems to be a “who-you-know” phenomenon.

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