Despite two major market declines in the last 14 years, the U.S. financial markets have been generous to investors and baby boomers have been perhaps the biggest beneficiaries.
Over the 30 year period from 1980 through 2012 the stock and bond markets returned roughly 10 percent and 6 percent respectively before inflation and about 7 percent and 3 percent after inflation.
The reality, however, is that over the last 30 years and especially in the aftermath of the 2008–2009 financial crisis, the investment landscape has been reshaped in a big way. A major factor has been the steady decline in interest rates that have driven the real (after-inflation) yields on U.S. Treasury bonds to near zero and in some cases even lower
This transition to a world of low real interest rates has implications across all asset classes and creates stresses and challenges for investors of every kind. For example, although bonds and stocks often behave differently in response to economic conditions and changes in the financial markets, there is a strong positive association between the level of real (after-inflation) interest rates and equity returns. In other words, other things equal, a low real interest rate world is often also a lower equity return world.
While both common sense and history tell us the past will likely prove to be a tough act to follow, investors from sophisticated institutional money managers to the average individual seem to be having difficulty adjusting to this reality. In more cases than not, they continue to incorporate overly optimistic long-term asset return assumptions in their planning.
Investors and advisors who choose to extrapolate the robust stock and bond market returns into the future do so at considerable risk to their financial futures, including their retirement security.
Since one of the most important variables in constructing retirement projections is the rate of return on investments prior to and during retirement, if realized returns turn out to be even slightly lower than expected, it can produce large shortfalls when compounded over a period of 30, 40 or more years, requiring an investor to drastically adjust plans for retirement.
The effects of lower investment returns are not limited to individual investors. Insurance companies that rely heavily on the earnings of invested premiums on certain types of policies (e.g. long-term care) to subsidize the payments of claims have been forced to raise premiums and lower dividend payments to policyholders. Public and private pension plans are facing enormous shortfalls between what they have promised current and future retirees and the funding levels of their plans. As a result, an increasing number of companies are terminating their old-fashion pension plans in favor of the 401(k) type plans and thereby shifting the responsibility to save sufficiently and invest prudently to the employee.
Both the sophisticated institutional investor and the average individual worker and retiree face a similar quandary: Adjusting and managing their savings and spending to live within their means while building their reserves, all within this new low-return environment.
While the prospect of lower bond yields has been evident for some time, less obvious yet equally important to investors has been the implication that these lower yields will have for other investment assets, including stocks. Smart investors will acknowledge this new reality and adjust their plans by saving more, spending less and investing more efficiently.
Next week we will discuss reasonable return expectations for U.S. stocks and bonds going forward.
John Spoto is the founder of Sentry Financial Planning in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com
This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions.