Academic studies and advisor conversations about retirement strategies typically focus on what withdrawal rates ensure that clients won’t run out of money. But what about those clients who seek to preserve their capital for the rest of their lives and beyond?

A confluence of factors like increasing longevity, historically low interest rates and high stock prices are prompting some advisors to rethink this entire subject. Some are concluding that clients who want to be sure they don’t outlive their money probably need to consider a withdrawal rate closer to 3% than the traditional 4% or 4.5%.

For those whose goal is to avoid “dipping into principal,” the quandary is more acute. This problem was the subject of a fascinating presentation from a different angle by Richard Marston, the James R.F. Guy professor of finance at the Wharton School, speaking at the Investments & Wealth Institute annual investment advisor conference earlier this year.

Imagine you were charged with managing a $100 million endowment with the goal of allowing it to give away money in perpetuity at a 3% rate. It’s the same problem, albeit with a different client.

Marston chose to examine this question with two different withdrawal rates, 3% and 5%, making it relevant to many types of retirees. He began his presentation, entitled “Investing in a World of Lower Returns,” by noting that industrial nations in the post-World War II era have been blessed by an extended period of peace and prosperity. Economies in North America, Japan and Western Europe have thrived thanks to early 20th century innovations. Marston cited the work of Northwestern University economist Richard Gordon who has argued that breakthroughs like electricity, antibiotics, running water and refrigeration changed the modern world far more dramatically than PCs and the internet.

Since 1951, equities as measured by the S&P 500 have generated 7.0% real returns while 10-year Treasury bonds have earned 2.6%. Marston’s 3% spending rule is applied to a portfolio that is 75% in stocks and 25% in bonds. Using these historical returns for endowment spending of 3%, Marston found there was a 25% chance the $100 million would grow to more than $263 million in inflation-adjusted terms during its first 20 years. There was a 20% chance it would grow to more than $120 million. Moreover, there was only an 18% chance it would decline by 18% or more.

There is one particular problem for U.S. private foundations. They are required to spend 5% annually by a 1981 law, a rate considered sustainable in the early 1980s. With a 5% rule, Marston found there was only a 50% chance of keeping the entire $100 million and a 10% chance that the portfolio would fall to $26.4 million in two decades.

Two Decades Of Low Returns

Since the financial crisis, there has been widespread discussion about the markets experiencing lower returns going forward. The fact that equities have soared in the last decade makes lower returns going forward even more likely, according to numerous academics.

Recently, a wealthy family asked Marston to develop an investment policy statement. He surveyed four private banks on what sort of investment returns they expected over the next 20 years. Many investment firms like to view the world through rose-colored glasses for marketing purposes, so the Wharton professor approached four private banks without brokerage arms.

The results were “sobering.” In nominal terms, the four firms expected bonds to return 3.4% to 3.6% and stocks to generate between 4.4% and 7.2%. After being adjusted for a 2% expected inflation rate, fixed-income returns fell to a 1.4% to 1.6% range, while equities fell to a 2.4% to 5.1% range. The latter represents a major decline from historical real returns of 7.0%.

As Marston noted, bond yields have fallen to the point where they can’t possibly offer healthy returns going forward. Yale University’s endowment has slashed its expected real return on bonds to 0.5%.

But why is there such a subdued outlook for equities, with the most optimistic private bank predicting real returns of 5.1%? Marston postulated that these institutions are simply taking the experience of the last two decades and projecting them into the future.

For the 20 years ended in December 2017, the S&P 500 returned 4.9% in real terms, compared to 7.1% for the entire 1951-2018 period. The two-decade period starting in 1998 encompassed two recessions and two bear markets with drops exceeding 50% in the S&P 500. There have only been two other corrections of that magnitude in the past century.

Europe and Asia didn’t experience a dot-com bubble, yet their returns trailed American stocks by a wide margin over the last two decades. Marston split the EAFE index into European and Pacific groups; he found that Europe generated a 3.7% real return while the Pacific nations (Japan, Australasia, Hong Kong and Singapore) produced an even more anemic 3.1%.

American Exceptionalism

Why have American equities outperformed their foreign counterparts by a wide margin over two decades? Many industries of the future, like technology, e-commerce, biotech, nanotechnology and social media, are concentrated in the U.S.

Marston asked why we should expect things to change. Still, many very smart investors like Jeremy Grantham and Rob Arnott are confident they will outperform domestic equities for a sustained period like they did in the so-called Lost Decade from 2000 to 2009. “I have emerging markets in my portfolio, but I don’t see them as a savior,” Marston acknowledged.

Over the last three decades, however, emerging markets have zigged when the S&P 500 has zagged. Both emerging markets and real estate trounced the S&P 500’s paltry 1.4% return between 2001 and 2010, a decade in which the MSCI Emerging Markets Index returned 16.2% and the NAREIT index recorded a 10.2% on an annualized basis. So far in this decade, emerging markets have proved very disappointing while real estate has trailed the S&P 500 by 3%.

At this point, Marston raised the question of whether there were any saviors—like real estate and alternative investments—or whether caution was the better part of valor. Real estate should be viewed as a source of equity-like returns, often with income, but little more.

Then Marston addressed the implications of lower returns on spending, using a real return on equities of 4.9% (the S&P return over the last 20 years) and real bond returns of 1.5%, or 1% below the average since 1951. Even with a 3% spending rate, there is nearly a 50% chance that the $100 million portfolio will suffer losses over 20 years and a 10% chance it will fall to $44.8 million.

Not surprisingly, the results from a 5% spending rate are much worse. There is a 50% chance the portfolio will drop by 50% and a 20% chance it will drop by more than 80% to $19.6 million.

There Are No Saviors

Can alternatives help generate higher returns? The performance of hedge funds has deteriorated dramatically from their glory days in the 1990s. “There are not 10,000 George Soroses out there,” Marston told attendees.

A Cambridge Associates study found that for the 10 years ending June 2018, hedge funds in the top 5% earned 7.5% more than the median. But the odds of your most affluent clients accessing those funds is slim indeed, Marston argued.

Private equity is a different story. Marston noted it has outperformed other asset classes, but he acknowledged that the typical retiree with $5 million can’t afford the illiquidity. Moreover, valuations “are high, like everywhere else,” he noted. “If I were rich, I’d have a significant allocation to private equity.” 

There are other complications, however. As with hedge funds, private equity performance dispersion is vast. Even wealthy families with hundreds of millions of dollars can’t access the same high-quality managers that the Yale endowment or the Swedish sovereign wealth fund can. Marston found that a portfolio with a 10% to 20% allocation to private equity (the exact figure would vary from year to year) over the last 20 years would enhance the return by an anemic 0.3%. The client or foundation might be able to increase the withdrawal rate from the 3% area toward 3.5%, but that’s “not a game-changer,” he said. It’s also important to remember that Marston examined withdrawal rates over a 20-year period; most advisors plan for a 30-year retirement.

Ten years into a bull market, many clients don’t realize that equity performance has been significantly lower for the last two decades than it was in the 20th century’s second half. One clue is that economic growth in both the U.S. and the rest of the world has declined over that period, Marston noted. In the last 17 years, GDP growth in the U.S. has averaged 1.8% annually. Despite a huge tax cut in 2018 and massive deficit spending, both of which were previously unheard of this late in the cycle, GDP growth “struggled to get to 3.0%” in 2018. Marston was speaking in mid-February, and the actual number came in at 2.9%. “That won’t last,” he predicted.

The low return-low growth problem isn’t confined to America. Marston cited Japan, where growth fell from 8% on average in the 1950s and 1960s to about 1% since 1991. France and Germany enjoyed 2% and 3% growth in the 1990s. Since 2001, eurozone growth has meandered around 1%.

An aging population and declining productivity—the latter is accelerated by an economy’s transition from manufacturing into service—are the two major drivers. Some of this was becoming apparent in the 1980s. Marston recalled the words of his former M.I.T. economics professor, Nobel laureate Robert Solow, who said at that time, “I see computers everywhere in America except in the productivity growth statistics.”

In September 2015, Wade Pfau and Wade Dokken authored an article in Financial Advisor examining how the famous 4% rule would have worked for a 60% stock/40% bond portfolio over 30-year periods between 1900 and 2013. Americans and Danes would have enjoyed a 95% success rate, while Canadians and New Zealanders would have fared better. Most Europeans would have seen a success rate of 76% or less.

“The safest thing is to assume the next 20 years will continue,” Marston concluded. “Maybe we’ll be pleasantly surprised.”