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September 1, 2013

The reality of lower investment returns

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.

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