“Nobody Has Ever Seen Anything Like This”: Implications for Retired or Soon-To-Be-Retired Investors?
As fiduciaries, we continually question whether our investment process is sound and likely to deliver the returns that our clients need to reach their goals. We draw from history, academic studies, common sense, and apply the lessons to today’s environment. We are generally skeptical of the oft-repeated phrase: “This time it’s different.” It is often abused to justify poor assumptions and flawed decisions. Yet, the current pandemic triggered some unprecedented policy responses from governments around the world.
Traditionally, investment professionals build portfolios around two main asset classes, stocks and bonds. The former provides long-term growth while the latter generates regular income. Historically, bonds had the added benefit of protecting portfolios during stock crashes. By changing the mix between the two, one could aim for an appropriate level of risk and return. Today, we are faced with an environment where stocks are at best fully valued, and bond yields are near generational lows. What does this imply for future returns? It is a particularly important question for investors approaching or in retirement.
What Does Stock Valuation Mean for Future Returns?
Valuation matters because the lower it is, the higher future aggregate stock returns will be. Remember that we are discussing capital markets, not the laws of physics. When the stock market is cheap, the probability of greater than average returns over the next decade increase, and vice versa. Today, few argue that, overall, the US stock market is indeed cheap. For instance, the S&P 500 index, an imperfect but broadly accepted representation, is expensive or fully valued at best by historical standards. True, pockets of under-valuation exist in the US: shares of small companies, financial, energy, industrials, and real estate stocks—to name a few—are trading at more attractive multiples. Valuations outside the US tend to be lower as well. Of course, any opinion about valuation is highly dependent on the level of interest rates. If rates remain low, the current level is reasonable. What happens if rates rise? Well… historically, stocks struggle.
Investing During Times of Very Low Bond Yields
As you know from looking at your savings accounts, interest rates are currently very low. Ten-year government debt yields less than 1% and bank savings accounts pay close to nothing. The last time interest rates were so low was during the 1950s. When looking at bonds, the current yield is a decent estimate of what an investor will earn over the life of the bond: If you buy a 10-year treasury bond paying 0.7%, this is what your average annual return will be for the next 10 years.
Stuck Between a Rock and a Hard Place
The combination of low interest rates and full stock valuations is likely to deliver lower than average investment returns over the coming decade. Moreover, while today’s record unemployment removes inflation as a near-term risk, trillions of dollars in monetary and fiscal stimulus could eventually lead to higher inflation down the road—further squeezing the purchasing power of retirees. Today’s pre-retirees should brace for a period of lower investment returns and focus on adjusting other elements of their retirement plan which are more within their immediate control.
What are today’s investors to do?
Rethinking your retirement strategy in this environment requires a broad review of your financial picture. First, take advantage of low rates to improve your household balance sheet:
- For your short-term liquidity needs and rainy-day fund, it pays to shop around. A good place to start to find the highest-paying savings accounts and CDs is to use online comparison tools such as bankrate.com. Do not keep your savings in accounts earning close to zero. You are just losing 1% to 1.5% per year to inflation.
- Refinance or accelerate paying down your mortgage and your student loans: See our prior piece on the subject last March: “Don’t just stand here. Do something!” If you carry credit card debt, paying it down or consolidating into a personal loan likely represents the highest possible risk-free return available to you.
The second step is to review your retirement plans:
- Historically, a sustainable spending guideline was 4% of the portfolio value. This number is likely too high today for most retirees. Could you afford to live on 3% instead? If not, consider retiring later or finding other sources of income, such as part-time work. Or consider a variable withdrawals strategy (call us for details);
- Delaying social security benefits to age 70 makes even more sense unless you have concerns about your health. Check this free social security strategy calculator for insights: Open Social Security.
- If your portfolio spending rate is creeping up, consider purchasing a Single Premium Immediate Annuity as you get older to reduce the risk of outliving your assets. Because bond yields are so low today, buying a deferred income annuity in your fifties or sixties should probably be avoided. However, as you grow older in your retirement years, annuities’ payouts increase because they are less dependent on interest rates, and more on your life expectancy. To review your options, check this website: ImmediateAnnuities.com
The third step is to review your investment portfolio:
- For investors with a time horizon of 10 years or more, consider taking advantage of market pullbacks to increase your target equity allocation over time. Your portfolio will be more volatile, but with a higher expected return. Whereas a typical 60/40 stocks-bonds mix might have done the job 10 years ago, a 75/25 balance might be necessary now to hit the returns that will allow you to retire securely. Try to ignore the quarter-to-quarter swings in value and focus instead on the growth in portfolio income over the years.
- Within your stock allocation, if you have been invested in US large cap stocks for the past several years, you are likely overweight to large cap growth stocks. Consider rebalancing a portion across the areas of the market that are less expensive: stocks from US small value, US large value, real estate, international and emerging markets.
- Within your bond allocation, ideally, we recommend keeping at least 5 years’ worth of annual spending. The idea is to create a buffer of stable assets to draw from if markets drop significantly. It will allow you to wait out a stock market recovery for a few years without drawing from that portion of the portfolio.
- Finally, when choosing bonds or bond funds, focus on short-term, high-quality issues. We do not recommend chasing higher yields by investing in bonds of companies with lower credit ratings. We acknowledge that your returns might barely keep up with inflation but remember from the point above that the goal here is safety. Once inflation or yields increase, you will be able to pick up bonds generating higher income.
As always, do not hesitate to reach out with questions about your situation.
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One of Bristlecone Value Partners’ principles is to communicate frequently, openly and honestly. We believe that our clients benefit from understanding our investment philosophy and process. Our views and opinions regarding investment prospects are "forward looking statements," which may or may not be accurate over the long term. While we believe we have a reasonable basis for our appraisals, and we have confidence in our opinions, actual results may differ materially from those we anticipate. Information provided in this blog should not be considered as a recommendation to purchase or sell any particular security. You can identify forward looking statements by words like "believe," "expect," "anticipate," or similar expressions when discussing particular portfolio holdings. We cannot assure future results and achievements. You should not place undue reliance on forward looking statements, which speak only as of the date of the blog entry. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. Our comments are intended to reflect trading activity in a mature, unrestricted portfolio and might not be representative of actual activity in all portfolios. Portfolio holdings are subject to change without notice. Current and future performance may be lower or higher than the performance quoted in this blog.
References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and returns do not reflect the deduction of advisory fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase.
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