Lower Returns Could Affect Retirement Plan

March 23, 2016

There is an article written by famed investor Warren Buffett at the apex of the dot.com stock market boom in 1999.  In the entertaining and informative missive,(Mr. Buffett on the Stock Market,Fortune, November 22, 1999), he laid out his reasoning why investment return expectations going forward were far too rosy at that time.  He also discussed two important factors that can heavily influence stock market returns; interest rates and economic growth.  Although economic and market conditions today are quite different now, it is worth looking at these two influences in today’s environment and consider some headwinds that could affect retirement in your future.

As Mr. Buffett pointed out, interest rate changes have a profound effect on financial markets, particularly bond investments.  When rates rise (or, in the case of the last couple of years, expected to rise), bond investment returns tend to be modest, if not below-average.  With US interest rates at their bottom already, rising interest rates down the road could be problematic for bonds to deliver decent (expected historical) returns.  Even if rates stay put, yields on new bonds could be lower than historically average and interest paid by banks on savings accounts and certificates of deposit could remain negligible.

The other factor, economic growth, affects corporate earnings; earnings being a major driver of stock market valuations.  Global growth is currently stagnant outside the US.  Our economy is chugging along,but at a below-average pace.  Inflation is quite low and corporate profit margins are already at the high-end of their historical range.  So there is an argument to be made that if aggregate corporate earnings don’t grow more than modestly (and it’s difficult for aggregate earnings to grow faster than the general economy), then stock market returns may also be modest as well, since the prices of investments are bid up and down based upon the price-to-earnings ratio that investors deem appropriate.

Since most investors have a diversified portfolio of stock and bond investments, along with other investments, if expected returns for stocks, bonds and bank savings are below average (or less than expected), the question then becomes: What if the assumed blended investment return used in your financial or investment plan doesn’t come to pass, (i.e. it falls short on average over the years)?  What then?

Even a percentage point or two lower than the projection can make a big difference.  Just ask public pension fund administrators.  Those who used return assumptions that were too aggressive years ago are feeling some pressure now, as their plans are severely underfunded and could result in compromised benefits or higher taxes to make up the shortfall.  What about your own private pension-retirement plan? If your return assumptions don’t come true it could mean a compromised retirement; working longer, living on less or having to save more.  If you don’t know what kind of compounded annual average return you’ll need or if you have a safety margin in case returns are less than expected, it would be a great idea to find out.  Knowing sooner rather than discovering later would be a wise move; at least now you’d have time to take measures to ensure that you’ve accounted for a low-return contingency in your retirement plan.