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Retirement

5 Strategies for a Low-Return Environment

Revisit your savings and withdrawal rates and asset allocation, and mind the corrosive effects of expenses, taxes, and inflation.

For the past several years, sober market watchers have been telling investors to brace for more modest returns from their portfolios. Just as trees don't grow to the sky, nor do extended market rallies go on forever.

Market fundamentals also suggest that more muted returns are likely in the offing. Starting yields have historically been a good predictor of total returns from bonds over the ensuing decade; today's Barclays U.S. Aggregate Bond Index yield of about 2.25% suggests that investors should check their return expectations for that asset class.

And while stocks could well continue to benefit from being the "cleanest dirty shirt"--the most palatable asset class in an underwhelming choice set--valuations could put a lid on stocks' gains. The Shiller CAPE ratio--which is a cyclically adjusted price/earnings ratio--has been hovering around 27, high given a median of 16. Morningstar's price/fair value chart doesn't send as pessimistic a message, but it does indicate that our analysts' coverage universe, in aggregate, is not especially cheap right now. Unfortunately, foreign stocks may not be a great return engine, either: As senior analyst Kevin McDevitt discussed in this article, major foreign stock market indexes were scraping new highs in 2014; negative currency effects, not stock performance, explain why U.S. investors' returns weren't so good.

Given that starting valuations have historically been one of the best predictors of market performance--with low valuations tending to lead to strong markets and high ones presaging tough ones--realistic investors would do well to ratchet down their return expectations for stocks, too.

If the market provides less of a helping hand in the future than it has in the past, that means that investors will need to do more of the heavy lifting to make their plans work: Bumping up their savings rates during their accumulation years and drawing less from their portfolios during retirement are two obvious ways to make up for muted returns. But investors can also take smaller-bore steps to improve their portfolios' take-home returns and, in turn, improve the viability of their plans.

Here are five strategies for making a save for your portfolio even if market returns are muted over the next decade or even longer.

Strategy 1: Revisit Key Assumptions The S&P 500 has returned about 20% on an annualized basis since the market bottomed in March 2009. But stocks' long-term returns have averaged less than half of that, and it's reasonable to assume that returns over the next decade could be even lower than that due to lofty valuations. To help factor in a less-forgiving market environment, it's a good time to revisit the key assumptions underpinning your retirement plan, whether you're still accumulating or already retired. If you're using a retirement calculator, take care to employ modest return assumptions; I would use 2% or so for bonds and 6% or thereabouts for stocks. If those lower return projections point to a shortfall in your retirement plan, you can then determine what steps you need to take to make a save, perhaps increasing your retirement-plan contributions, decreasing planned in-retirement spending, pushing back your retirement start date, or reducing your in-retirement withdrawals. Employing a combination of the aforementioned steps may help you salvage your plan without taking drastic measures.

Strategy 2: Assess Your Asset Allocation It's difficult to predict the future returns of stocks: While starting valuations have historically been one of the best predictors, factors such as economic growth and innovation can also shape market performance. Bond returns, by contrast, are easier to predict. As noted above, starting yields on Treasury bonds have explained much of their performance over the subsequent decade. That means that with yields as low as they are, an investor who hunkers down in bonds and forsakes stocks could well be locking herself into a very low return. Investors who maintain higher equity positions won't necessarily get rich, but they will at least have a fighting chance of outrunning inflation over time. That's not to suggest that you throw standard asset-allocation guidance out the window: Individuals who expect to draw money from their portfolios in the near or even intermediate term absolutely need cash and bonds. But it does suggest that the safety of cash and bonds could prove illusory over longer time frames.

Strategy 3: Watch Investment Costs Like a Hawk Lower returns on a going-forward basis also mean that efforts to control a portfolio's various cost measures will be even more beneficial than in a higher-returning environment. After all, paying a 1% expense ratio on a balanced portfolio that earns 10% on an annualized basis--as the typical balanced portfolio has during the past five years--takes a 10% bite out of that return; if balanced funds return just 6%, as they have during the past decade, that 1% expense ratio translates into a 17% levy on the portfolio's return. Given those numbers, investors' stampede into various types of inexpensive passively managed products, both index funds and ETFs, looks quite rational.

Strategy 4: Aim to Reduce the Drag of Taxes In a similar vein, lower returns mean that taxes take a bigger bite of your portfolio's value, on a percentage basis, than in a more flush return environment. Lower absolute returns enhance the tax-saving features of vehicle like IRAs, company retirement plans, and 529 college-savings plans; once their tax benefits are factored in, even subpar versions of these accounts usually trump investing in a taxable account and paying taxes on dividends and capital gains on a year-in, year-out basis. That said, investors who are in a position to invest in their taxable accounts alongside tax-sheltered vehicles (and that should be the case with higher-income individuals) can take steps to reduce the drag of taxes on an ongoing basis: Favoring exchange-traded funds and index funds, individual stocks, and municipal bonds, as well as limiting trading, can go a long way toward reducing annual tax bills on taxable holdings. (Total stock market ETFs and index funds can have tax-cost ratios of less than 0.5% per year, whereas many actively managed equity funds have tax-cost ratios in excess of 2%.)

Strategy 5: Build a Bulwark Against Inflation Like expenses and taxes, inflation is a bigger deal when returns are lower than when they're more lush. Inflation has been pretty benign for the past several years, prompting many investors to jettison inflation-protective investments like TIPS. But they do so at their own peril. Of course, stocks provide investors with the best long-term shot at outrunning inflation, so young investors with ample equity stakes who are not spending from their portfolios don't need to go out of their way to add insulation against rising prices. They're likely to receive periodic wage increases that help offset higher prices in their working years, and returns from their stock holdings will likely beat inflation. But explicit inflation protection is more important for retirees who have a healthy share of their portfolios staked in fixed-rate investments like bonds and cash and are actively spending from their portfolios.

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