A Money magazine article published Sept. 2, “Why Your 401(k) May Only Return 4%,” makes this point: “The biggest dilemma in retirement investing may be how hard it will be to grow our savings in the next decade.”
The author makes the case that in the coming decade, “investors are likely to earn returns of just 3% for bonds and 4% for equities” — a big drop from the “average annual 10% return (in the US stock market) over the last 40 years.” Given the fact that many financial planners have used (and continue to use) 8% to 10% as the expected returns for stocks, many retirees — especially those in the final stretch nearing retirement — may experience a significant shortfall in retirement assets from what they had expected. The article goes on to say that the “only real solution … is to save more and spend less.”
The article does not go into a great deal of detail as to the reason(s) for the anticipated low U.S. stock return projection other than to say that GDP growth “may get stuck at 2% for the long term.” While slow growth, no doubt, will be the likely culprit, the fact that current U.S. equities valuations are at a historical high point is another reason that equity returns ought to be modest, at best.
A recent Invesco blog post, “Two Reasons to Consider Emerging Markets Now: Growth Potential and Recent Valuations” examines the impact of valuations on future returns. The article found that, based on the Shiller P/E ratio, the P/E for U.S. stocks was 25.3x on June 30, 2014. Going back to January 1900, whenever the P/E of U.S. stocks is greater than 25x, the median annualized five-year forward return was 0.04%. Consequently, it would appear that the argument for lower U.S. returns is rooted in both projected slow growth and the current high valuation of the U.S. stock market.
The Invesco post also points out the fact that emerging market (EM) equities, which were trading at 15.1x as of June 30, 2014, have historically experienced a median annualized five-year forward return of 9.1%. If this historical valuation/return pattern should turn out to repeat itself over the next five to 10 years, investors with a significant allocation to EM could see lower U.S. returns offset by higher EM returns.
Unfortunately, according to a recent Forbes article, “What your Investment Portfolio is Likely Lacking,” DC investors nearing retirement — who can benefit the most from higher returns — tend to have the lowest allocation for international equities. The article cites several sources supporting the author’s conclusion that, “The U.S. stock market has had another great year so far… but if you’re 50+, there’s a good chance you’ve missed out on gains from international stocks.” The article points to a recent major study which “discovered that the older the age group, the less the international diversification in their 401(k) plans … the youngest employees had nearly a quarter of their 401(k) holdings (24%) in international stocks, while those in their mid-50s and older only had about 15%.” Considering that EM is a smaller subset of international equities, these mid-50s and older investors are, on average, unlikely to experience much upside from EM. This is, of course, if there is indeed a major rotation into this asset class over the next five to 10 years.
Conclusion
There seems to be an emerging consensus that the U.S. stock market — due to slow growth and high valuations — is expected to have lower returns over the next five to 10 years. While a growing number of analysts believe that now is the time to invest more globally, the DC investors closest to retirement are less inclined to embrace investing outside of the Unites States. This is in spite of the fact that, as the Forbes article demonstrates, blending U.S. and international equities actually lowers risks while increasing return. While that observation is “Investing 101” for the typical plan advisor, it is obviously less apparent to those DC investors who need the diversifying benefits of international investing the most.
The best means of responding to the need for DC investors to be in risk-appropriate allocations, including international/EM equities, is through the utilization of asset allocations programs such as target date funds and managed accounts. Even though adding international equities to the mix has historically reduced risk while increasing returns, it is not something that is apparent to many participants, who think mostly about the impact of a single asset class on a stand-alone basis. Many participants — especially those who were nearing retirement during the 2008-2009 bear market and experienced the dramatic fall in asset prices — would be much better off utilizing a professional asset allocator who considers how asset classes behave when grouped together versus standing alone.
