U.S. investors have experienced strong market returns over the past 10 years due to a steady economic recovery and supportive, low interest rates. We’re now in the midst of the second longest bull market since World War II, and many investors are feeling increasingly confident in their wealth and future prospects. Some are beginning to spend more, while others are considering leaving their primary careers earlier than expected, feeling their savings are sufficient to secure a comfortable lifestyle for them going forward. Unfortunately, the future doesn’t look as rosy, and there’s good reason to expect lower returns for most asset classes, challenging traditional approaches to funding our clients’ lifestyles and cash flow obligations.
Market experts are forecasting investment returns that not only revert to historical means, but also in some cases, fall even lower due to current conditions. Lacking reasonable approaches to respond, clients are already often seeking inappropriate investment risks on their own in a quest to meet their income needs. Prudent advisors will start using lower return assumptions in their modeling and will start discussing a broader range of strategies to meet clients’ income needs.
Is 3% to 4% the New 5% to 6%?
For many years, it’s been reasonable to expect a well allocated balanced portfolio to grow 5% to 6% on average over time. This was easily achieved when, for the past 50 years, the long-term return on U.S. stock and bond investments was over 7% on average (based on annual returns for the S&P 500 and the Aggregate Bond Index). Today, many market strategists and economists are reducing their long-term return expectations for the stock and bond markets below these historical means. Based on declining interest rates, the potential for a recession in the next couple years and lower levels of productive economic assets in the United States, strategists are offering up forecasts for the next 10 years that are meaningfully lower than return assumptions many advisors have used for years in financial cash flow planning models.
In its 2019 annual Long-Term Capital Market Assumptions, J.P. Morgan Asset Management predicts 10-year future U.S. equity returns will be a modest 5.25%, down from 7.5% in 2014.1 BlackRock Investment Institute’s Capital Markets Assumption for the next decade is a slightly higher 5.9% as of April 2019.2 John Bogle, the founder of Vanguard Group, predicted in late 2018 that U.S. equity returns over the next decade would be conservatively 4% to 5%,3 while the firm’s Investment Strategy Group for 2019 forecasted an even lower 3% to 5% U.S. equity return for the next decade.4 As a final example, Morningstar Investment Management came in at a meager 1.8% nominal return prediction for 10-year U.S. equity returns.5 These equity expectations are in sharp contrast to the 7% to 8% kind of estimates many advisors have been using in their models for future equity returns.
Fixed income return forecasts haven’t declined quite as much as equities from historical returns, but they still may be more aggressive than clients want if we’re returning to an environment in which the Federal Funds rate is at 1% or less. Currently, J.P. Morgan Asset Management foresees a robust 4.5% return for U.S. corporate bonds, but this prediction was based on interest rates moving up.6 Morningstar Investment Management is slightly lower at 3.3%,7 and BlackRock Investment Institute projects 2.9%,8 all well below today’s prevailing 10-year corporate bond yields.
Most of these assumptions were published at the beginning of 2019, when the Federal Reserve was expected to continue to normalize U.S. interest rates. As of June of 2019, the United States was experiencing its longest economic cycle in history (Australia still has the record with its current expansion at 27 years and counting). Now, after several years of working toward “normalized” interest rates in the United States, our Federal Reserve is signaling that its next move will be to lower rates in an effort to avoid a recession. It’ll be instructive to watch if these assumptions change further with this outlook.
What’s evident is that clients will need a change of thinking to meet their income needs. Advisors will need to start by updating how portfolios are modeled and managed for future withdrawals based on lower return expectations. For many years, it’s been reasonable for annual withdrawals of 4% to 5% for either lifestyle needs or distribution requirements from portfolios. Going forward, advisors should start to model 3% to 4% returns as a base case, no longer a downside “stress” test.
High Yield or Junk?
Even more importantly, we need to begin to prepare our clients and offer up solutions that can keep them committed to reasonable long-term investment strategies. Already, as interest rates have declined, we’ve seen many investors gravitate to increasingly risky strategies in their traditional search for portfolio income. Unfortunately, the rules of risk and reward have always held; to earn income that exceeds the risk-free rate available on government bonds, investors must take on riskier investments. Advisors need to help investors and trustees stick to choices that are suitable for their portfolios.
The fixed income market has traditionally been the source of income for many investors and, more recently, these investors are seen trying to boost their income in one of two ways. First, investors may invest in longer maturity bonds rather than appropriate term risk. By investing in longer maturity bonds, investors seek to earn a higher payment for waiting longer for their returns. The risks of longer maturities are higher volatility and market uncertainty. If low interest rates aren’t the new normal, and interest rates move higher again, investors holding long-term bonds may find themselves with meaningful investment losses. As rates go up, long maturity bond prices fall more than shorter maturity bond prices. This might occur at the same time clients need to withdraw income. Long maturity bonds also expose investors to the potential risk of unexpected future inflation, locking in returns today that fail to maintain purchasing power in the future. These risks may be appropriate for some investors, trusts or foundations with very long time horizons, but the risk may be very inappropriate for older clients, no matter their income needs. The proper term risk for clients clearly shouldn’t be defined by the income on fixed income, but rather by the time frame for the goals and objectives of the client.
The second way your clients may be seeking to boost their income from bonds is by taking on higher credit risk—the risk above the safety of risk-free U.S. Treasury bonds. More and more investors have even added high yield funds to their investments in which a majority of the securities have a credit rating below investment grade. These securities have significant credit risk and can be much more volatile than safer investments. In fact, when markets declined in the fourth quarter of 2018, these same funds were the worst performing fixed income investment sector, losing over 4.5%. Strategies that involve investments that aren’t worthy of an investment-grade rating are in direct conflict with the traditional role of fixed income as portfolio protection. It may do well for advisors to remind investors that today’s high yield is the same investment sector as the 90s “junk,” and it’s probably inappropriate for most retirees, foundations or trusts to take on this kind of extreme credit risk in their fixed income allocations.
Safe fixed income investments are meant to allow investors to balance higher potential growth and risk in the equity market. Instead of focusing on that growth, however, income-focused equity investors may also be taking on too much risk by increasingly pursuing high dividend paying investments, similarly irrespective of the potential higher risk inherent in their choices. Dividend-paying stocks have long been considered a cornerstone of a safe equity portfolio, but particularly high dividend-paying stocks generally add unnecessary risk to a portfolio. Dividends are the portion of a company’s profits that are shared with investors and not reinvested in the company. If the ratio of dividends to profits is too high, or even exceeds profits, the future growth of a company may be at risk. Conversely, if the company can’t sustainably afford to pay the dividend, the high dividend may be at risk. When companies are forced to cut their dividend, their stock usually declines as well. In this way, investors that favor too many high dividend paying stocks in their portfolio for the sake of generating income take on much more investment risk than they generally realize.
All of these may be investment strategies that aren’t appropriate for some of our clients pursuing them. As advisors, it’s our job to help investors navigate today’s market choices and plan successfully for the future by embracing a portfolio with the appropriate asset allocation and appropriate risk for their circumstances.
Cash Flow Strategies
Both individual investors and trustees have easily been able to meet their cash flow and distribution needs historically, based on a “safe” 4% retiree withdrawal rate or 5% foundation distribution. Today, navigating a lower return future requires that we help investors think in different ways. It may also require new portfolio construction strategies that can respond to declining returns. The best way to help our clients embrace these changes is to refresh our income and cash flow planning conversations. We must walk our clients through strategies that can meet their personal needs in a lower return future environment. Here are a few such strategies you might start discussing with clients:
1. Total return approach. Many soon-to-be and current retirees may have been told by their own parents that they should live on the income from their portfolios, not the principal investment. But, we need to tell our clients, “This is not your parents’ interest rate environment!” We’re working with clients who saw their parents withdraw only income when interest rates were slowly declining from a high of over 15% in 1981. Their parents likely owned high quality bonds that paid regular interest at a rate in excess of 10%. With this level of interest rates, investors then actually could withdraw the income naturally generated by their portfolios, and they may have never needed to withdraw any part of their invested principal. Since then, however, interest rates have only continued to go down; steadily declining for 30 years, in fact.
With expectations of both declining interest rates and equity returns dropping to potentially less than 2%, retirees need to look at things through a different lens. Withdrawals from portfolios will need to encapsulate all types of returns, from collecting fixed interest income, dividends from high quality investments and some portion of the capital growth of their investments.
“Total return” refers to all components of a portfolio’s return. It’s the combination of the income as well as the capital appreciation in a portfolio. When we talk to our clients about their future needs for income from their portfolios, we’ll likely be explaining to them that a total return strategy best fits their needs. This is a big change from the messages they may have heard from their own parents. As advisors, our job is to explain that a total return approach responds to the very low interest rate environment we’re already in. By withdrawing funds from both income and growth sources, the fixed income allocation of client portfolios can continue to focus on quality and protection instead of income. This approach mitigates the tendency to chase income by introducing inappropriate risk. We can further explain to clients that these total return withdrawals may still maintain the value of their portfolios over the long term. If their investments continue to grow at a rate that can exceed their principal withdrawals, the overall portfolio can still maintain its value and perhaps even grow over time with a total return strategy.
2. Spend down principal. The most common question individual investors ask their advisors is, “Will my money last?” In response, advisors typically model estimated cash flow needs to age 95 or even 100 these days. Often, advisors may even model varying market environments to estimate the probability that funds will last. Such models usually assume that wealth will decline in that a retiree’s original portfolio value will go down each year until the end of life.
In reality, few of our clients are prepared to experience this decline. As noted, they’ve probably experienced historical returns much greater than their cash flow needs, and they’re used to portfolios that maintain their value while supporting their lifestyle or distribution needs. If, however, retirees and trustees are required to withdraw 4% to 5% each year for personal reasons or tax and estate reasons, even a total return approach in the future may not be sufficient. Withdrawal rates of 4% to 5% may no longer be sustainable, and over time, they may eat into wealth.
Advisors need to be prepared to help clients spend down the principal of their wealth, trusts and even their foundations. Here, an advisor may need to act as much to manage a client’s emotional reaction as the financial consequence. Most long-term allocations and cash flow models allow for declining balances, but a limited number of investors are comfortable seeing balances decline, even if slowly. Trustees and fiduciaries have real responsibilities to meet distribution requirements that have been pegged by both tradition as well as the Internal Revenue Service. If, indeed, we’re facing a much lower return for the next three years or the next 15, we must model portfolios that slowly decline in value to support cash flow needs. Our goal is to define the potential and likely life of these assets and help make our clients become comfortable with this decline.
3. Change the funding sources. Reinvesting, living within tighter means and supplementing distributions could be the difference among a long life, a legacy and a dynasty. In a lower return environment, a 4% to 5% portfolio withdrawal rate may no longer be the gold standard of sustainable withdrawals. Recent research has even suggested that with current reduced return forecasts, retirees may not only need to spend down their portfolios, but also, in varying scenarios, portfolios may not even last a lifetime almost 50% of the time.9 This conclusion, by definition, must also suggest a potential limited life for trusts, endowments and foundations burdened with 5% required distributions.
This is a daunting outlook to share with clients, and one that requires a suggested response at the same time. Total return and spending portfolios may help, but ultimately, clients may need to change their funding sources. Advisors and clients need to realize that unless they’re willing to think outside of the box, plan for the long term and have realistic expectations, long-term assets may fail to reach their end points.
For some clients, advisors may introduce different investment allocations when appropriate. For clients with a very long time horizon, it may make sense to consider investing portfolios away from the traditional means to seek more diversified sources of growth and sustainable income. If appropriate, investors with a suitable risk profile may expand their investment opportunity universe to include all global opportunities, as well as alternative investments and illiquid investments. (See “Considering Alternative Risks in Portfolios,” by Edward J. Finley II, p. 56). While these asset sectors often include more risk and volatility, they may offer reliable sources of sustainable income and returns to long-term investors.
Though much less desirable, advisors may need to discuss reducing cash flow needs with some clients. Soon-to-be retirees may choose to delay full retirement. Clients who remain in family homes and locations that accommodated their families for many years may need to review the fixed costs associated with current housing and cars. Trust beneficiaries may need to reinvest part of their distributions to sustain their portfolios for years to come. Finally, for others, the discussions might need to ultimately include ways to supplement income with occasional work or steady part-time employment.
Economists aren’t always right; market strategists aren’t always right; and the future may be rosier than many current predictions. As advisors, though, it’s our job to model the future in reasonable and cautious ways that suit our client’s needs. Today, that means we must consider a potential recession in the next year or next three years; we must contemplate interest rates that decline by 1% or even 2.5%, and we must plan for a future with little to no inflation. Advisors must build models for the worst in hopes that it doesn’t come to fruition. These will be reasonable plans going forward, and they’re likely to suggest that clients need different strategies in the future to support their lifestyle needs or the distribution requirements of their portfolios. It’s the advisor’s job to help make clients comfortable with this possible future by discussing reasonable strategies for success.
—The author extends special thanks to her research assistant, Joel Sims.
Endnotes
1. “2019 J.P. Morgan Long-term Capital Market Assumptions,” J.P. Morgan Asset Management, https://am.jpmorgan.com/gb/en/asset-management/gim/adv/insights/ltcma-2019. “Long-term Capital Market Return Assumptions,” 2014, J.P. Morgan Asset Management, https://am.jpmorgan.com/blobcontent/1383169768793/83456/11_973US.pdf.
2. BlackRock Investment Institute (April 2019), www.blackrock.com/institutions/en-us/insights/charts/capital-market-assumptions.
3. Christine Benz, Experts Forecast Long-Term Stock and Bond Returns: 2019 Edition, Morningstar (Jan. 10, 2019), www.morningstar.com/articles/907378/experts-forecast-longterm-stock-and-bond-returns-2.
4. Ibid.
5. Ibid.
6. Supra note 1.
7. Supra note 3.
8. Supra note 2.
9. Michael Finke, Wade D. Pfau and David M. Blanchett, “The 4 Percent Rule Is Not Safe in a Low-Yield World,” Journal of Financial Planning 26 (6): 46–55 (2013).