Forget the New Normal. The Old Normal, coupled with some realistic assumptions about the future, is scary enough.
That was the perspective Wharton School of Finance professor Richard Marston shared with attendees at IMCA’s annual investment conference in New York in February. Despite what many advisors and their clients think, near-retirees and recent retirees may be better-positioned than future generations, even though many spent their peak earning years during the so-called lost decade that witnessed two savage bear markets.
Sequential risk remains the topic du jour ever since the 2008 financial crisis. “If you are born at the wrong time, or are in your accumulation years or retire at the wrong time, you [could] have a very different experience,” Marston said. As evidence, he pointed to individuals who retired in the 1960s or early 1970s, a period when bonds performed worse than equities, which went sideways before inflation.
Then Marston went on to examine several variants of the New Normal scenario—both past and future versions—that was conceived by Pimco in 2009. It should be noted that while the economy has followed Pimco’s new economic vision characterized by slow growth, high deficits and corporate and consumer deleveraging almost to a script, the financial markets, particularly equities, have rebelled violently against it.
This may partially explain why Pimco’s Bill Gross may have suffered a miserable year in 2013, when the Standard & Poor’s 500 returned 32%. During decades of outperforming his peers, Gross often got the big picture wrong and still made the right bets on individual bonds. But in a “what have you done for me lately” world, the tables appear to have turned on him.
Nonetheless, Marston indicated that it was perfectly reasonable—indeed incumbent upon advisors—to envision a scenario like Gross’s New Normal in which returns on financial assets trailed historical returns for an extended period. Growth in the industrialized world has slowed, he said. Even if the U.S. doesn’t face the same demographic challenges of other developed nations like many European nations and Japan, ultimately there must be a degree of linkage between the economy and the markets.
Paramount among the reasons to study this potential outcome is the likelihood that fixed-income markets will produce very modest real returns over the next two decades. Had bonds not offered investors double-digit yields in 1981, it is certain they never would have given fixed-income investors a three-decade tailwind to earn outsized returns. That same tailwind almost as certainly propelled equities.
Other respected investors agree. In an interview late last year, Research Affiliates CEO Rob Arnott decried the tendency of big pension plans to use the recent past to project future returns. Equities display repeated patterns of outperforming for a decade or more and then disappointing investors who get to the party late in the game. Against the backdrop of several centuries in financial history, the experience of bonds over the last three decades appears to be a one-time anomaly unlikely to happen again whereas equities probably will continue to remain predictably unpredictable.
Over the next two decades, Marston predicted the verdict on our national experiment with defined contribution plans replacing defined benefit will be decided. Many have already judged that experiment to be a failure, and the Wharton professor acknowledged they have some powerful facts on their side. Today, calls for expanding Social Security are coming from the political left, but Marston suspected mainstream politicians, including Republicans, could eventually join them.
If the New Normal prevails—meaning a 4.5% real annualized rate of return on equities and a 1.5% real returns on bonds—then standard retirement rules like Bill Bengen’s 4.5% withdrawal rate for retirees and a 15% savings rate for workers won’t cut the mustard. Of course, no one knows what the future will bring, so Marston compared several unpleasant scenarios.
For starters, the last decade or so hasn’t been nearly as bad as the inflation-ravaged 1970s. Between November 1968 and July 1982, stocks lost 3.2% a year in real terms and long-term Treasury bonds cost investors 3.4% annually. Inflation, not slow growth, is the “ultimate nightmare” for investors.
Marston provided a simplified series of examples of an investor with a $1 million portfolio, 50% of which was in the S&P 500 while the rest was in long-term Treasurys, and used a 4% withdrawal rate. The hypothetical investors retired in five-year intervals starting in 1950 going up to 1990. The only investor who ran out of money after 25 years was the one who retired in 1965. However, retirees who left the workforce in 1955, 1960 and 1970 all suffered serious losses of capital.
Then Marston looked at another case of an investor who retired in October 2007 with $1 million who was far more diversified with a portfolio of 45% U.S. bonds, 5% cash, 25% U.S. stocks, 18% foreign stocks and 7% REITs. If this investor withdrew 4% a year, he was down only 9% by 2012 right before a big year for equities. If the investor had not retired, he’d have $1.175 million. Even if the investor had retired in 2000, Marston said his portfolio would have remained largely intact. Needless to say, a retiree who panicked and bailed out of stocks in October 2002 or February 2009 would be forced to change his or her lifestyle permanently. Marston’s analysis has been confirmed by others like Research Affiliates’ Arnott, who made a powerful case that an investor who was broadly diversified in a cross-section of asset classes including emerging markets, commodities and REITs would have done just fine for most of the lost decade—until 2008 when everything but long-term Treasurys collapsed.
The Great Recession left many assumptions—from rates of return to realistic savings and retirement withdrawal—subject to second-guessing in recent years. J.P. Morgan recently released a study questioning the static 4% rule, advocating a dynamic model that allows clients to adjust their spending in retirement as their goals, wealth and risk tolerance change. In reality, most advisors have been doing exactly this for years. Moreover, when crises hit like they did in 2008, clients don’t need to be told to dial down spending.
The Old Normal Is Scary Enough
April 1, 2014
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