Despite this clear relationship, the retirement calculators at respected investment management firms—those with hundreds of billions of US dollars of client assets—appear anchored on history. For example, Vanguard2 uses a 4.0% real (after inflation) annualized long-term expected return. Dimensional Fund Advisors assumes real annualized long-term expected returns of 1.0% and 5.0% for global bonds and global stocks, respectively, implying a real return of roughly 3.9% for a 60/40 global portfolio.3 At first blush, these estimates seem entirely reasonable, and maybe even prudent. Indeed, looking back, a conventional 60/40 US stock/bond blend would have achieved real annualized returns exceeding 4.0% in each of the past 5-, 10-, 20-, 30-, and 40-year periods.
So, why is it unrealistic to expect the same in the future? After all, the past 40 years have witnessed a variety of economic and political regimes and should be a reasonable proxy for the future. To answer this, it is necessary to understand the sources of past returns, going as far back as possible. Let’s focus on equities, the lion’s share of a 60/40 allocation’s return. As Arnott and Bernstein (2002) explain, the majority of the real return on stocks over the past two centuries came from three sources: 1) dividends paid, 2) real growth in dividends paid, and 3) rising valuation levels. Valuation matters. Over the last 40 years ending June 30, 2017, rising valuation levels’ contribution to the annualized real return of the US stock market approaches one-third (2.1% of 7.4%).4
Today, yields are dramatically lower, and equity valuations are dramatically higher. The average bond yield over the last 40 years was 6.7% (Barclays Capital US Aggregate), and the average cyclically adjusted price-to-earnings (CAPE) ratio was 21.1 times. As of August 31, 2017, these measures are 2.4% and 30.3 times, respectively.5 In other words, today we are experiencing some of the lowest yields and highest equity valuations in modern history. Expecting bond yields to fall even further and CAPE ratios to continue soaring doesn’t seem sensible—but that’s precisely what’s happening when investors and their advisors rely on history to gauge the future.
The Asset Allocation Interactive (AAI) tool on our website offers two methods to determine expected returns over the next 10 years. The default method assumes valuations will revert halfway back to a normal historical level (“Valuation Dependent”), while the second method simply assumes valuations won’t change (“Yield Plus Growth”).6 According to AAI, the asset mix of the Vanguard Target Retirement 2025 Fund produces real annualized expected returns of 1.7% and 2.8%, respectively, under the two forecasting methods, both well below Vanguard’s stated expected return.
Let’s look at how this may play out. Assume you are the trusted financial advisor of 55-year-old Lawyer Larry, who’s done just about everything right in planning for his retirement. Since the age of 25, he diligently saved, banking 10% of his annual wages every year, and now has nearly $825,000 in retirement savings.7 Larry dreams of retiring in 10 years. Cognizant of his spending and lifestyle desires, Larry thinks he’ll need at least $1.35 million before he can retire.
Larry turns to you for advice. Can he achieve his dream of retiring in 10 years? What balance can he expect to have at age 65? That depends. Using Vanguard’s real expected return of 4.0%, he would have a projected balance in his retirement account of over $1.36 million in 2027. Using the 1.7% default estimate from AAI indicates he should expect to have less than $1.10 million a decade from now, a shortfall of 20–25% (given rounding error). Ouch!
Could Vanguard’s expected return be right? Quite possibly, and what a delightful conversation that would be. But if Vanguard’s forecast (or any forecast for that matter) misses the mark an investor is relying on, there is no do-over. In that case, Larry would come up short. Larry deserves to hear the hard truth in order to explore his options for making up a potential shortfall in his retirement account, whether that option is saving more,8 more broadly diversifying, or possibly postponing retirement.