Random Walker wrote: ↑
Tue Sep 10, 2019 10:37 pm
Larry has an essay over on Advisor Perspectives discussing the challenges of retirement in a low interest rate and high equity valuation environment.
Thanks for letting us know about that Dave. For those interested, the link to that piece is here
Larry does a good job explaining why forward returns for both stocks and bonds are expected to be lower.
In fact, with the CAPE 10 at 28.5 (August 15, 2019), the expected real return to U.S. stocks is now just 3.5% (1/28.5). If we use the current spread between 10-year nominal Treasury securitiees [sic] and 10-year TIPS as our estimate of inflation, the result (1.5%) produces an expected nominal return to U.S. stocks of just 5.0% (3.5 +1.5). If, instead, we use the current 10-year inflation swap rate of about 1.8% (a cleaner estimate of expected inflation), we get an expected nominal return of 5.3% (3.5 + 1.8). If we combine that 5.3% expected return with the five-year Treasury note now yielding at about 1.4%, the expected nominal return of that 60/40 portfolio is now only about 3.8%, or less than 40% of the return earned in the prior 37 years. (International stocks have lower valuations and thus higher expected returns. Using data from AQR Capital Management, at the end of the second quarter, the CAPE 10 earnings yield for international developed markets was 5.3% [versus 3.3% for the U.S.] and 6.9% for emerging markets.)
However, he misses a key point, one that Michael Kitces discovered
back in 2012.
Accordingly, while 30-year returns have little relationship to safe withdrawal rates, returns over the first 15 years of the retirement time horizon have a much stronger relationship; in fact, the 15-year real (inflation-adjusted) return of the portfolio actually has a whopping 0.91 correlation to the safe withdrawal rate, as shown in the graph below.
So the first 15 years' of returns have seemingly been highly
predictive of the forward 30 year SWR.
The average real return on a 60/40 (re-)balanced portfolio associated with the worst safe withdrawal rate scenarios in history was a mere 0.86% average annual compound growth rate over the first 15 years of retirement.
Larry is claiming that the expected real return of an all U.S. 60/40 portfolio over the next 10 years is roughly 2%. I would argue that 10 year TIPS would be a much safer bet for someone relying on 4% withdrawals than nominal Treasuries in this situation since Larry is stating that 5 year Treasuries have a -.4% expected return, while 10 year TIPS' real return today is .06% (30 year is .47%). TIPS also remove the risk of unexpected inflation from the fixed income side of the portfolio. International diversification of the equities would also increase the real portfolio return, so with these two changes, the real return of a 60/40 would increase to 2.7%.
While 2.7% real is nothing to crow about, and that's just for the next 10, not 15, years, it's still not low enough to seriously threaten the 4% rule going forward. It's certainly possible
that the 4% rule won't hold over the next 30 years, but 2.7% real is unlikely to do it. If it's looking like real returns will be 1% or lower over the next 10-15 years, then there will be a lot more room for concern, IMHO.
And I'm disappointed that Larry is still recommending Monte Carlo simulations without using any disclaimers to the widely known fact that they produce 'fat tails' unless they specifically incorporate mean reversion.
Definitely not his best work.
P.S.: The real return of an all U.S. 60/40 portfolio from 2000-2009 was a very meager .38%, and yet year 2000 retirees who strictly held to the 4% rule are in fine shape today
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings