Kitces: Preparing for Lower Long-Term Returns

[audreyh1]

Interesting Kitces interview at M* where he discusses the predictive capability of Shiller CAPE and points out that 15 years has the best predictive capability which happens to correspond to that initial period which can make or break portfolio survival.

You can read the transcript if you don't want to watch the video
Preparing for Lower Long-Term Returns

So, we find out that Shiller P/E ratios are actually quite good at predicting things like 15-year real returns in equities--which ironically tells you very little about how to invest your portfolio right now. But it tells you a whole lot when you are trying to make decisions like how much can I safely spend from my portfolio, how much risk do I want to take overall in the next decade, and do I even have enough money to retire? Those sorts of questions are greatly impacted by market valuation.

We really find it's that eight to 15-year time period where it's really powerful, which matters a lot for, say, retirees thinking about sequence-of-return risk and accumulators who might be in their 40s or 50s and could be 10 or 15 years away from retirement and are trying to figure out whether the market is likely to cooperate with their portfolio growth and getting them to the finish line. But you have to be careful not to either focus too short or too long.

 

[petershk]

Interesting.
I'm not RE yet, but am FI. Still wrestling with the timing etc... but I noticed that market performance effects my spending habits probably as much as it impacts my portfolio.

I can't imagine dropping my portfolio 30% and spending like nothing happened any more than I could see it double and be equally conservative.

So for DW and I having flexibility is spending is key.

I haven't looked but I wonder if there is research done in that area. So not whether 3% or 5% is SWR in different conditions but what % of your spending is flexible.

At this point in our lives a lot would have to go wrong for us to be un-FI'ed. That wasn't true even 5 years ago.

Sent from my HTC One_M8 using Early Retirement Forum mobile app

 

[papadad111]

Kites: Preparing for Lower Long-Term Returns

What was the conclusion on the next 15 years and what SWR is he suggesting based on PE ? I couldn't open the link.

I think now days, super safe is being redefined ... For those with long horizons, in their 40s ....and drawing down by being FIREd, not adding in...it looks to be similar to the broad market dividend yield. In other worlds between 2.1-2.5% ... Or no more than 50 bps above the 10 year treasury yield.

Edit. Got into the video. Looks like he says 2 percent real return. So spend 2 percent and the portfolio will just stay up with inflation. So a 2 % WR if you are in 40s looking at another 40 -50 years or more of FIRE makes sense

 

[marko]

But if inflation remains tame doesn't that mitigate? IOW, 5% return with 3% inflation is not as good as 3% return with no inflation. Yes?

 

[samclem]

But if inflation remains tame doesn't that mitigate? IOW, 5% return with 3% inflation is not as good as 3% return with no inflation. Yes?

No. If the 2% growth is "real" (as stated by papadad111, and it does appear to be what Kitces is talking about), then inflation is immaterial.

The good news? Well, for folks who are looking out beyond 10-20 years:

Now, ironically, what we also see in the data is that this really does tend to move in cycles. In a bad instance, by the end, valuation gets so cheap that the next 10 to 15 years often is very good. So, I guess the small silver lining for this is that although it suggests market returns may not be great from now through the end of the 2020s, the 2030s and 2040s could turn out to be a very good time to be an investor. And again, that means the 30-year time period may actually be quite reasonable. But it certainly suggests lower returns over the next 10 or 15 years, and there really isn't any place to hide--those low returns tend to be across the board.

In the past, Kitces (and Pfau) have proposed a method of adjusting AA based on PE10. Historically, that has offered better returns (or equivalent returns at reduced portfolio volatility) than fixed AAs. More here. It appears useful to me. I wouldn't go 100% stocks/100 bonds based on it, but moving the allocation line 15-30% or so (e.g. from 70s/30b to 50s/50b) seems like something I could live with. But one will need to be prepared to be "wrong" for a >long< time.

 

[MichaelB]

GMO used to project asset prices over 11 year periods (IIRC) but then shortened at period to 7 years, saying their research showed that, on average, that was the time it took for prices to return to their median trend. How can anyone project asset returns 15 years from now?

Even if the longer term projection were possible, it doesn't make sense to base a 40 year portfolio plan on a 7 to 15 year return estimate.

In addition, a long period of low returns does not mean low returns each year, it means a long period with high volatility, which lowers the annualized average. A balanced, diversified portfolio with disciplined rebalancing can sustain a withdrawal rate that is higher than the annualized average rate of return with a reasonable probability of survival.

 

[target2019]

http://news.morningstar.com/cover/videocenter.aspx?id=738361

I'm able to get to that link on my phone. Time to read...

 

[marko]

No. If the 2% growth is "real" (as stated by papadad111, and it does appear to be what Kitces is talking about), then inflation is immaterial.
.

So we're talking about a 2% growth OVER inflation, right?

 

[samclem]

So we're talking about a 2% growth OVER inflation, right?

Yes. "Real" growth means "adjusted for inflation." If you see the term "nominal growth", it means that it has >not< been adjusted for inflation. "Real growth" always represents an increase in the true value of the investment, but "nominal growth" could represent a "real" loss (i.e. if the nominal growth was 3% but inflation was 5% during that period, then the investment lost about 2% in real value).

Too often the writers don't tell us whether they are talking "real" or "nominal," and that leads to a lot of confusion.

 

[audreyh1]

Link Preparing for Lower Long-Term Returns

Don't know why the first link went bad.

Actually the first link worked again when I tried it again. Who knows - flaky links. Keep trying or navigate from the main M* page. It's a Christine Benz interview.

 

[Gone4Good]

What was the conclusion on the next 15 years and what SWR is he suggesting based on PE ?

My approach is to discount current markets back to a level that represents the median valuation of the data set used to originally calculate your SWR. If you're using FIRECalc and PE-10, that would mean discounting the current equity market down to a valuation of about 16x from it's current 24x (a 33% haircut).

I'd also do the same thing with the bond market. 10-year treasuries are yielding 1.74% versus a median of 3.89%. Using an average bond market duration of about 6 years, that 200bp lower current yield results in a price discount of about 12%.

So assuming a 1MM portfolio and a 50/50 asset allocation, I'd mark the $500,000 in stocks down by 33% to $333,000 and the bond allocation down by 12% to $440,000.

My resulting $773,000 portfolio puts me right in the middle of the valuations used in our historic data set. Applying a 4% SWR, I get a withdrawal of about $31,000.

That means my undiscounted portfolio can support a withdrawal rate of 3.1%. Said another way, a 3.1% withdrawal today is equivalent to a 4% withdrawal at median valuations.

 

[ronin]

He's got that annoying habit of inserting "actually" into every sentence. Well, actually, maybe not every actual sentence. Is it really actually predictive or just predictive? At least he doesn't end every sentence with the new punctuation word, right?

 

[Gone4Good]

This analysis matches my intuition.

Holding stocks long-term is similar to holding bonds to maturity . . . you earn your current yield.

At a 24x PE, we're getting an earnings yield of about 4%. At 16x we're getting an earnings yield of 6.25%. Therefore, all else being equal, you expect to earn 200bp less from stocks today over the long term than if you bought them at median valuations.

 

[papadad111]

Kites: Preparing for Lower Long-Term Returns

So we're talking about a 2% growth OVER inflation, right?

Yes. That's what I mean by 2 percent real return. 2 percent growth above the rate of inflation. That is what Kitces suggests.

So ... Drawing 2 percent off of that portfolio in his scenario for the next 15 years ... leaves 0 percent real return ... The portfolio buying power over time just just just keeps pace with and offsets the ravages of the expected inflation rate.

Interestingly a well diversified all equity portfolio will yield approx 2.2-2.4 percent annual dividend yield today ... Or about 50 bps above the 10 year (yielding 1.8 pct).

And if Kitces is correct in his low growth 2% real return, then one can in effect just " spend the dividends" ... A safe withdraw rate at a low (15%) tax rate .. And the market will return enough to keep the base portfolio flat to inflation ..... In theory ... of course.

* edit to add in a 100 percent equity portfolio.

 

[Gone4Good]

And if Kitces is correct in his low growth 2% real return, then one can in effect just " spend the dividends" ... A safe withdraw rate at a low (15%) tax rate .. And the market will return enough to keep the base portfolio flat to inflation ..... In theory ... of course.

Assuming your portfolio is 100% equities.

 

[samclem]

Even if the longer term projection were possible, it doesn't make sense to base a 40 year portfolio plan on a 7 to 15 year return estimate.

Possible utility of knowing that there's a high likelihood of low equity returns over the next 10 years, even if one's "window" is 40 years:
- If the expected 10-year return from stocks is low relative to their volatility, maybe it makes sense to reduce the %age we hold in stocks. If we later increase our stock holdings when valuations are lower, we'll be selling high, buying low. It's the same thing we do across assets when we periodically rebalance, but instead of doing it across assets, we're doing it across time (valuations). (None dare call it DMT! )
- Early retirees may (logically) make different spending/drawdown decisions over the next 8-10 years if they reasonably expect their returns to be low. This has implications for whether to pay off the mortgage, delay discretionary spending, etc.
- There's considerable value in knowing that they have an elevated chance of "sequence of returns risk." At the very least, in 10 years or so, having a valuation-based explanation for why their returns have been low (and the accompanying expectation that their new lower valuations portend better growth later) may help them stay in the market when it counts.

 

[FUEGO]

My resulting $773,000 portfolio puts me right in the middle of the valuations used in our historic data set. Applying a 4% SWR, I get a withdrawal of about $31,000.

That means my undiscounted portfolio can support a withdrawal rate of 3.1%. Said another way, a 3.1% withdrawal today is equivalent to a 4% withdrawal at median valuations.

Is this a belts, suspenders, and safety pin approach? The 4% SWR is already 95% safe and includes all the past years of high PE10-15 in the calculation to get to 4% SWR.

 

[walkinwood]

Has Kitces written about the relationship between current CAPE and SWR over periods of 30-40 years? And how do you account for current bond yields in that relationship?

To me, in the de-accumulation phase, that's the important data point.

 

[Another Reader]

My takeaway from this is that it probably makes more sense to pay off my rental mortgages and lighten up on dumping money into paper asset investing, because my rental mortgages are at relatively high rates (low 5's to 6 percent). I have pensions, RMD's from inherited IRA's, and the gubmint dole known as SS as the income floor, plus the net rental income. The relatively risk free return that lowers my debt exposure is awfully enticing. Thoughts?

 

[MichaelB]

Possible utility of knowing that there's a high likelihood of low equity returns over the next 10 years, even if one's "window" is 40 years:
- If the expected 10-year return from stocks is low relative to their volatility, maybe it makes sense to reduce the %age we hold in stocks. If we later increase our stock holdings when valuations are lower, we'll be selling high, buying low. It's the same thing we do across assets when we periodically rebalance, but instead of doing it across assets, we're doing it across time (valuations). (None dare call it DMT! )
- Early retirees may (logically) make different spending/drawdown decisions over the next 8-10 years if they reasonably expect their returns to be low. This has implications for whether to pay off the mortgage, delay discretionary spending, etc.
- There's considerable value in knowing that they have an elevated chance of "sequence of returns risk." At the very least, in 10 years or so, having a valuation-based explanation for why their returns have been low (and the accompanying expectation that their new lower valuations portend better growth later) may help them stay in the market when it counts.

No disagreement that there is utility in that number, or that it implies sequence of return risk is higher. That's not the same as saying the retirement plan should be based on the entire period delivering these low returns.

 

[Gone4Good]

Is this a belts, suspenders, and safety pin approach? The 4% SWR is already 95% safe and includes all the past years of high PE10-15 in the calculation to get to 4% SWR.

How many 30+ year periods in the data set start with valuations of both stocks and bonds as high as those currently? I count 0. How many started with just equity valuations above 24x? Basically 2, around 1900 and again in 1928-29.

If we're using data to project for periods where we know the starting conditions lie outside the data set then it is wise to proceed with caution . . . or, at the very least, make adjustments to bring your starting position back in line with the available data.

 

[newtoseattle]

table of "real" returns needed

I copied and pasted a table below (from early retirement extreme blog site- I hope that is not poor etiquette for blogging - not trying to "steal" anyone's hard work). rows are your net worth (i.e. 33 is 3% SWR (33 times spending), 25=4%, etc). columns are years. It shows the real returns you need for your planned retirement to last however many years. Of course, it is not accounting for any sequence of return risk. Still, I like the table and found it helpful. (i.e. so if you're counting on a 3% withdrawal rate and a 40 year timeline, you'd need 0.98% real return. if you end up living another 10 years and need 50 year timeline, then your real returns would have needed to be 1.77%)

I guess for me it means that even though real returns might only be 2%, that 3% withdrawal rate is still quite reasonable for long retirement (and even 4% swr for someone planning only 30 years)


NW 20 30 40 50 60 70 80
10 7.76% 9.31% 9.76% 9.92% 9.97% 9.99% 10.00%
11 6.53% 8.25% 8.78% 8.97% 9.05% 9.08% 9.09%
12 5.46% 7.34% 7.95% 8.17% 8.27% 8.31% 8.32%
13 4.51% 6.55% 7.22% 7.49% 7.60% 7.65% 7.68%
14 3.67% 5.85% 6.59% 6.89% 7.03% 7.09% 7.12%
15 2.92% 5.22% 6.03% 6.37% 6.52% 6.60% 6.63%
16 2.23% 4.66% 5.53% 5.90% 6.07% 6.16% 6.20%
17 1.61% 4.15% 5.07% 5.48% 5.67% 5.77% 5.82%
18 1.03% 3.68% 4.66% 5.10% 5.31% 5.42% 5.48%
19 0.50% 3.25% 4.28% 4.75% 4.98% 5.11% 5.17%
20 0.00% 2.85% 3.94% 4.43% 4.68% 4.82% 4.90%
21 -0.46% 2.48% 3.61% 4.14% 4.41% 4.56% 4.64%
22 -0.89% 2.14% 3.31% 3.87% 4.15% 4.31% 4.41%
23 -1.29% 1.81% 3.04% 3.61% 3.92% 4.09% 4.19%
24 -1.67% 1.51% 2.77% 3.38% 3.70% 3.88% 3.99%
25 -2.03% 1.22% 2.53% 3.16% 3.49% 3.69% 3.80%
26 -2.37% 0.95% 2.30% 2.95% 3.30% 3.51% 3.63%
27 -2.70% 0.70% 2.08% 2.75% 3.12% 3.33% 3.47%
28 -3.01% 0.46% 1.87% 2.57% 2.95% 3.17% 3.31%
29 -3.30% 0.23% 1.68% 2.39% 2.79% 3.02% 3.17%
30 -3.58% 0.00% 1.49% 2.23% 2.64% 2.88% 3.03%
31 -3.85% -0.21% 1.31% 2.07% 2.49% 2.74% 2.90%
32 -4.11% -0.41% 1.14% 1.92% 2.35% 2.62% 2.78%
33 -4.35% -0.60% 0.98% 1.77% 2.22% 2.49% 2.66%
34 -4.59% -0.78% 0.82% 1.64% 2.10% 2.38% 2.55%
35 -4.82% -0.96% 0.67% 1.50% 1.98% 2.26% 2.45%
36 -5.04% -1.13% 0.53% 1.38% 1.86% 2.16% 2.35%
37 -5.25% -1.30% 0.39% 1.26% 1.75% 2.05% 2.25%
38 -5.46% -1.46% 0.26% 1.14% 1.64% 1.96% 2.16%
39 -5.66% -1.61% 0.13% 1.03% 1.54% 1.86% 2.07%
40 -5.85% -1.76% 0.00% 0.92% 1.44% 1.77% 1.98%
41 -6.03% -1.90% -0.11% 0.81% 1.35% 1.68% 1.90%
42 -6.22% -2.04% -0.23% 0.71% 1.26% 1.60% 1.82%
43 -6.39% -2.18% -0.34% 0.61% 1.17% 1.52% 1.75%
44 -6.56% -2.31% -0.45% 0.52% 1.08% 1.44% 1.67%
45 -6.72% -2.43% -0.56% 0.43% 1.00% 1.36% 1.60%
46 -6.89% -2.56% -0.66% 0.34% 0.92% 1.29% 1.53%
47 -7.04% -2.68% -0.76% 0.25% 0.84% 1.22% 1.47%
48 -7.19% -2.79% -0.86% 0.17% 0.77% 1.15% 1.40%
49 -7.34% -2.91% -0.95% 0.08% 0.69% 1.08% 1.34%
50 -7.49% -3.02% -1.04% 0.00% 0.62% 1.02% 1.28%

 

[Gone4Good]

if you're counting on a 3% withdrawal rate and a 40 year timeline, you'd need 0.98% real return.

That's probably right if you assume a constant 1% real return.

Do you know how these are calculated? I think volatility and adverse sequence of returns might bring those numbers down quite a bit.

 

[newtoseattle]

yes - I think you are correct. It does not account for sequence of return risk. (But, of course, the premise of the discussion was that the next 15 years would have the 2% real return)

 

[Meadbh]

My takeaway from this is that it probably makes more sense to pay off my rental mortgages and lighten up on dumping money into paper asset investing, because my rental mortgages are at relatively high rates (low 5's to 6 percent). I have pensions, RMD's from inherited IRA's, and the gubmint dole known as SS as the income floor, plus the net rental income. The relatively risk free return that lowers my debt exposure is awfully enticing. Thoughts?

That makes sense to me. I have been doing likewise with a rental mortgage at ~4.17%. The downside is that the ROI on the leveraged investment decreases. The upside is a guaranteed rate of return. I don't know anywhere else you can get 5-6% these days!