Interest rates are falling and with that comes a series of problems investors must confront. There are the obvious implications, like lower returns from bonds. But the more pernicious harm will come from thee failure to properly adapt financial plans to current market conditions.
I will review the economic conditions that are driving rates down and then turn to the effect on investors and their financial plans.
Investors have plenty to worry about: the trade war between the U.S. and China, and a significant slowing of the Chinese economy (the second largest); the failure of the U.K. to negotiate a trade deal with the E.U. as Brexit approaches and its economy (the fifth largest) shrank in the second quarter; the German economy (the fourth largest) hovering on the edge of recession, with the GDP falling in the second quarter as exports slumped; and protests in Hong Kong (the fifth largest stock market in the world by country). These events have led to a heightened sense of uncertainty – which investors dislike and a flight to safety (often referred to as “risk off” trades), which in turn has led to a dramatic fall in interest rates for government bonds all over the globe.
Rates have fallen so sharply that we now have more than $17 trillion in government debt with negative interest rates. For example, on September 4, 2019, the yield on the 10-year German bund had fallen to -0.68%, and the 30-year bund was yielding -0.16%. (They were even lower over the past few weeks.). Perhaps the most surprising development is that Danish banks are now providing 10-year home mortgage loans with a negative interest rate (-0.5%).
The U.S. is viewed as the relatively safe haven from a trade war, as the percentage of our GDP that is export-related is much less than that of most other developed nations. According to the World Bank, exports as a percentage of our GDP are about 12%, only about one-fourth that of the almost 46% figure for the Eurozone. This dramatic difference helps explain the stronger performance of U.S. equity markets (and their much higher current valuations) and relatively higher U.S. interest rates, as compared to other developed nations.
The sharp fall in rates around the globe, reflective of concerns over the risks of a global recession, has pulled down U.S. interest rates. Our Treasury securities are still providing significantly higher yields than other countries despite our 30-year bond yield falling below 2% for the first time ever! On September 4, the yield on the benchmark 10-year Treasury was 1.46%, down 39 basis points in the last month alone, and down 144 basis points in the past year. And with the yield on the two-year Treasury at 1.44%, the curve was slightly inverted (as traditionally measured) by a few basis points over the prior few weeks. The concern is that an inverted yield curve has predicted each of the last nine recessions. (See my thoughts on a yield curve inversion here.)
Investors should be aware of three important implications of the sharp drop in rates. We’ll begin by discussing how the sharp fall in rates has created a problem for unfunded corporate and state and local pension plans.
- Falling rates negatively impact pension plans
The fall in rates means both that the present value of liabilities (obligations) is higher and the rate of return that can be earned on bond investments is lower – requiring greater contributions by plan sponsors. This is a serious problem for states such as Illinois, Kentucky, Connecticut and New Jersey, which already face significant underfunding and deficits. And should a recession occur, their budget problems will deepen even further, as revenues would fall at the same time required contributions increase.
- Falling rates limit recession-fighting tools
While we began the year with the market forecasting one more increase in the federal funds rate, the slowing global economy has the market expecting that following its cut of 25 basis points at the July meeting, the Federal Reserve will cut rates by 0.25% three more times in 2019. Should that occur, the federal funds rate would be 1.25%. At that level, the Federal Reserve would not have much ammunition left to fight an actual recession – should one occur – with stimulative monetary policies (although there would still be room for quantitative easing). And with the country already running a trillion-dollar deficit, there is less political support for fiscal stimulus. This creates further risks for the economy.
- Expected returns for stocks and bonds are much lower than historical returns
Over the past 37 calendar years (1982-2018), a typical 60/40 portfolio (represented by 60% S&P 500/40% five-year Treasury notes) returned 10%. Unfortunately, many individuals build their investment plans based on historical returns, which can be a big mistake. Let’s examine why.
Equity returns were higher over that period than they have been historically, with the S&P 500 returning 11.3%. One reason for that strong performance was that valuations rose dramatically, with the CAPE 10 increasing from 7.4 to 28.4. Such an increase is highly unlikely to be repeated. In fact, with the CAPE 10 at 28.5 (August 15, 2019), the expected real return to U.S. stocks is now just 3.5% (1/28.5). If we use the current spread between 10-year nominal Treasury securitiees and 10-year TIPS as our estimate of inflation, the result (1.5%) produces an expected nominal return to U.S. stocks of just 5.0% (3.5 +1.5). If, instead, we use the current 10-year inflation swap rate of about 1.8% (a cleaner estimate of expected inflation), we get an expected nominal return of 5.3% (3.5 + 1.8). If we combine that 5.3% expected return with the five-year Treasury note now yielding at about 1.4%, the expected nominal return of that 60/40 portfolio is now only about 3.8%, or less than 40% of the return earned in the prior 37 years. (International stocks have lower valuations and thus higher expected returns. Using data from AQR Capital Management, at the end of the second quarter, the CAPE 10 earnings yield for international developed markets was 5.3% [versus 3.3% for the U.S.] and 6.9% for emerging markets.)
For those with equity allocations below 60%, typical for most retirees, expected portfolio returns are even lower. As we age and enter retirement, there are good reasons for individuals to lower equity allocations. Labor capital is no longer available. Thus, equity risk as a percentage of our total capital (financial plus labor) at risk is now higher. In addition, the lack of income from labor capital likely reduces investor willingness to take risk. The income from labor capital that allows investors to avoid having to sell stocks in bear markets is now absent. That lack of labor capital leads to the need to generate cash flow from the portfolio, creating what is known as “sequence risk” – a sequence of negative returns that can deplete a retirement income portfolio to the point where it lacks sufficient dollars to recover. That also reduces the ability, and likely the willingness, to take risk. Investment horizons become shorter, again reducing the ability to take risk. For these reasons, a “rule of thumb” to help guide investors had been to limit the equity allocation to 100 minus your age. With expected life spans increasing, the rule has been moved up to 110 or even 120 minus your age. But even at 120 minus your age, a 65-year old couple would have a suggested equity allocation of 55%, and that would decline over time. Finally, because of the risks of equity investing, many retirees simply cannot tolerate the risks of equity allocations as high as 60%.
With those concepts in mind, we can examine the expected returns of portfolios with lower equity allocations. As demonstrated above, the 60/40 portfolio now has an expected return of 3.8%. A 50/50 portfolio would have an expected return of 3.4%, a 40/60 portfolio would have an expected return of 3.0%, and a 30/70 portfolio would have an expected return of just 2.6%.
What are the implications of such low expected returns in terms of safe withdrawal rates?
Living in a low-expected-return world
Based on groundbreaking work by Bill Bengen, a rule of thumb was developed that stated, based on the historical evidence, investors with a 30-year horizon could expect to be able to safely withdraw 4% of their starting portfolio each year and adjust that for inflation – doing so resulted in very low odds of a portfolio depleting. However, that rule was based on periods when equity valuations were much lower (and thus expected returns were much higher) and real interest rates were much higher. Today, real interest rates around the globe are either very close to zero or negative, even for those willing to purchase very long-term nominal bonds. That means that the safe withdrawal rate is now lower.
Bengen only examined U.S. results. The study “Refining the Failure Rate” by Javier Estrada covered 21 countries over the 115-year period from 1900 through 2014. Estrada found that over the 86 30-year retirement periods he considered, a 4% withdrawal strategy from a global 60/40 portfolio would have failed 20 times, or in 23% of the periods. In some cases, the plan failed with only two years remaining; in others, it failed with 14 years remaining. Those represent two very different outcomes, with very different consequences. Yet they both count the same way in informing the failure rate.
In today’s world of lower expected returns, and with life spans increasing, a 4% rule is too aggressive unless one has options (e.g., reducing spending or liquidating non-essential assets) they are willing and able to exercise if sequence risk appears or returns turn out to be significantly lower than expected. Investors without such options should use a lower withdrawal rate. The best way to determine your appropriate withdrawal rate and asset allocation is to run a Monte Carlo simulation, making sure the inputs are based on current valuations, not historical returns.
How to think about expected returns
The expected return for stocks should only be considered as the mean of a potential wide dispersion of returns. The reason is that earnings can grow faster or slower than expected, and valuations can rise or fall as the risk premium demanded by investors changes with the economic regime. Thus, it is possible that the economy could grow faster (slower) than expected. If that occurred, it would likely produce faster (slower) than expected growth in earnings. However, such a change would likely be relatively minor, as GNP growth over the long term has been fairly stable in the 2-3% range. On the other hand, valuations can change dramatically, rising or falling. However, since we are already at historically high levels, it is more likely that if a change occurred, it would be that valuations fall, negatively impacting returns. Thus, while returns could be either higher or lower than expected, the risks are skewed to the downside – especially in terms of magnitude. At the very least, financial plans need to consider the possibility that valuations might fall and returns might be even lower, and what impact that would have on the ability to achieve financial goals.
How interest rates influence risk aversion
Consider these words of caution. Research, including the study “Low Interest Rates and Risk Taking: Evidence from Individual Investment Decisions,” has found that low interest rates lead investors to take on more risk, for example, by stretching for yield, purchasing dividend-paying stocks or high-yield bonds. This may cause their portfolio allocation to risky assets to exceed their ability and willingness to take risk. The likely outcome is that if the risks actually appear, panicked selling will result, leading to the almost certain failure of the plan.
Before concluding, there is one more important issue to discuss.
Low interest rates and flat/inverted yield curves can cause slower economic growth
While it may seem counterintuitive, lower interest rates can negatively impact the economy. Lower rates reduce the income savers receive, reducing their ability to spend. Very low real rates can lead to inefficient investments and the misallocation of capital as the hurdle rates required fall. Low rates can lead to a loss of deposits for banks, dampening their ability to lend. Low rates, combined with a flat/inverted curve, negatively impact the banking sector’s ability to generate profits, further dampening lending activity and slowing economic growth. Lastly, lower rates can even drive up the cost of insurance products as the investment returns insurers rely on fall. As an example, with lower rates, the buyer of a deferred-income annuity (DIA) has to give up more capital to generate the same income stream, negatively impacting their ability to spend.
Conclusion
Given the importance of the issues we have been discussing, be sure to review your financial plans to be determine if, given current expected returns, your clients will be likely to achieve their goals. Make sure you are not using historical returns to estimate future returns. Instead, use current valuations and yields to estimate future returns. If current valuations/yields result in unacceptable outcomes (low odds of success in Monte Carlo simulations), the plan should be altered to minimize the risk of failure (running out of assets while still alive). Actions such as lowering future spending goals, saving more by cutting current spending, moving to a lower cost of living/lower tax area, and downsizing homes should be considered. Forewarned is forearmed.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.
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