Q: My nest egg is invested in a relatively simple portfolio of stock and bond index funds. What's a reasonable rate of return for me to expect in the future?
A: You ask an important question. Clearly, the returns you earn will affect such issues as how much you need to save each year to build a nest egg large enough to support you in retirement and how much you can reasonably expect to draw from savings year to year during retirement without depleting your stash prematurely. So you want your planning to be based on return assumptions that are realistic.
Spending tips for a secure retirement
Unfortunately, it appears that many people's expectations may be a bit too, shall we say, exuberant. When asset manager Black Rock queried more than 1,000 401(k) investors for its latest DC Pulse Survey, 66% expected returns on their savings over the next decade to be in line with what they've experienced in the past, while another 17% believed returns will be even higher.
Maybe that optimism stems from the fact that stocks have returned close to an annualized 18% over the past eight years or so. Or perhaps it's because the stock market has had a nice bump since the election of Donald Trump.
But given today's low interest rates (recently about 2.3% for 10-year Treasuries) and relatively rich stock valuations (Yale finance professor Robert Shiller's cyclically adjusted P/E ratio for the stock market recently stood at 29.2 vs. an average of 16.7 since 1900), it would seem to strain credulity to expect anything close to the annualized returns of 10% for stocks and 5% for bonds over the past 90 years or so, let alone the dizzying gains the market has generated from its post-financial crisis lows.
So what level of future returns might be considered reasonable? Well, one way to get an idea is to take a look at what large investment firms are anticipating. For example, every quarter BlackRock publishes capital market assumptions about a wide range of asset classes. In its most recent forecast, BlackRock expects long-term (10 years plus) annualized gains of 5.9% for U.S. stocks and 3.1% for U.S. bonds. Vanguard also recently published a 2017 economic and market outlook in which the fund giant had a median forecast for the next 10 years of 6.6% for stocks and 3.1% for bonds.
Neither I nor anyone else can guarantee that these forecasts -- or a similar 2017 long-term outlook by J.P. Morgan that expects slightly different, although comparable, returns -- will turn out to be right on the money. In fact, I'd be surprised if they were. There are just too many variables and uncertainties involved in predicting how the financial markets will perform to expect anything close to pinpoint accuracy.
All in all, however, these returns seem, to me at least, to be in the ballpark. You can quibble about whether they could be a bit higher or lower. But if you take the time to read through the analyses in these reports, I think you'll find that the main thrust is sound -- namely, given current conditions in the economy and the stock and bond markets, returns over the long-term are likely to trail the returns that investors enjoyed in the past by a substantial margin.
Even if you assume these projections are largely on target, the return that you or any other individual investor will earn may differ for a number of reasons. The expected returns cited above are for broad market averages (although the reports also detail assumptions for narrower asset classes). So you might earn more, or less, depending on whether your stock holdings are tilted more toward small-caps vs. large-caps or whether you focus more on short-term than intermediate-term bonds.
Similarly, the gains you earn will vary based on how you divvy up your portfolio between stocks and bonds, as well as on whether you stick to your stocks-bonds mix (and periodically rebalance to do so) or jump in and out of the market or shift your mix around in an attempt to capitalize on a shifting market. And, of course, costs are a major factor. Research from Morningstar shows that the less you pay in investment fees and expenses, the higher your returns will generally be.
I can understand why many people might be tempted to compensate for lower expected returns by investing more aggressively -- say, loading up more on stocks or tilting their portfolio mix to small caps or tech -- in hopes of boosting returns. That would be a mistake. While such a move can lead to bigger gains, it comes at the expense of higher volatility, and the possibility of seeing your portfolio get hammered with big losses if we see a repeat of a 2008-style bear market.
Ideal withdrawal rate in retirement
So lower returns or no, your investing strategy should still largely reflect your risk tolerance as well as how long you expect to have your money invested. You can ensure that your portfolio mix of stocks and bonds jibes with your investing time horizon and tolerance for risk by completing this asset allocation-risk tolerance questionnaire.
And whatever asset mix you eventually settle on, you'll squeeze the most out of whatever gains the market delivers by sticking to funds with low annual expenses. By putting together a portfolio of broad stock and bond index funds (as you apparently have done), you can reduce annual expenses in some cases to as little as 0.10% a year or less vs. upwards of 1% or more annually for actively managed funds.
More likely than not you're also going to have to save more. Clearly, if you're setting aside 10% of salary each year into a retirement account and the return you earn drops a couple of percentage points, you'll end up with a significantly lower nest egg come retirement time unless you boost your savings rate. Ideally, you'd want to do that as quickly as possible. But if you simply can't afford to save an additional 2% or 3% of salary immediately, you can do so gradually by increasing it by a percentage point every year or so or by saving half of any pay raises you receive.
And if reducing investment fees and saving more isn't enough to compensate for lower returns? In that case, you may have to resort to other measures like staying on the job a few years longer to give your nest egg more time to grow or postponing Social Security benefits to qualify for a bigger check.
If, on the other hand, you're already retired, then the right way to deal with lower returns may be to pare living expenses where possible, tap home equity by downsizing or signing up for a reverse mortgage, taking on a part-time job or even relocating to a part of the country where the cost of living is lower.
The point, though, is that while no one knows for sure what size gains the financial markets will deliver in the years ahead, the likely scenario is that they'll be lower, perhaps much lower, than in the past.
You can choose to ignore the possibility of muted returns and hope that the forecasts are wrong. But the more prudent response is to start fine tuning your retirement strategy now to reduce the chance you'll have to take more drastic measures later on.