Recently, I ran across a heated debate in an online discussion group about the returns used in various projections provided to clients. The debate started with one poster concerned about future returns. In particular, he worried that the Monte Carlo simulation engine in his software was using the long-term historical returns for U.S. Treasurys as the proxy for bonds. He pointed out that with yields so low, illustrating a return near 5% had to be unrealistic.

His solution was to change the default in his software to use the current yield on the 10-year U.S. Treasury as the mean. Other posters suggested it was easier to just knock off a percent or two from the portfolio return parameters across the board.

Another poster quickly pointed out that the characterization of “unrealistic” had some embedded assumptions in it. Illustrating the viability of a retirement usually means a multi-decade time frame. Is it fair to assume that today’s rates will persist that long?

This triggered discussion about future equity return expectations. Valuations are above the historic average, suggesting lower-than-average returns going forward. Will that actually happen? Valuations have been above average for years. Maybe something is different now. Even if that is not the case, will valuations remain high for the next few decades?

The debate shifted from questions about how to alter the parameters to one of altering with historical data or something else. It’s a worthy conversation.

One thing the historical record has going for it is that it describes real life. The returns are not theoretical—they actually happened. The stock market crashed in 1929, and financial markets during the Great Depression were extremely volatile. Inflation was very high through the ’70s. Corrections occurred every other year, on average. Almost every president was in office when a “bear market” 20% decline in stock prices hit.

Yet the good ole “4% rule” never failed. There should be some comfort in that for clients and their planners.

However, that record is far from a guarantee of future results. Just because something has always worked doesn’t mean it always will, and just because something has never happened doesn’t mean it can’t. Plus, there are aspects of the historical record that are less than comforting.

The 4% statistic is a U.S. phenomenon. Isolating other countries generally yields poorer results, according to Wade Pfau, professor of retirement income at the American College of Financial Services. There have been periods in which yields were low and there have been periods where equity valuations have been high, but before the last few years, there had not been a time when yields were near historic lows and valuations near historic highs.

This nagging truth begs an exploration of what could happen.

First « 1 2 3 » Next