Navigating the New Retirement World

Making Do With Less
A short essay by BlackRock's Robert Kapito in the 40th anniversary issue of the Journal of Portfolio Management, "Long Lives and New Strategies," summarizes the new retirement conundrum. As life spans have grown, expected asset-class returns have shrunk. The reverse, of course, would make for an easier investment task, although it would disappoint in other ways.

That people are living longer than in generations past is indisputable. That investment returns will be lower is not. However, modest bond yields, high stock-market price/earnings multiples, and the broad popularity of investing suggest that the easy money has already been made. Such is the overwhelming consensus of those who attempt to forecast asset returns. They might be wrong--but they are the way to bet.

Below are intermediate- to long-term projections for real annualized returns on major investment assets from three prominent sources: Rob Arnott's Research Affiliates; partnership Grantham, Mayo, Van Otterloo; and researcher William Bernstein. They are dismal. None have any use for U.S. fixed income, short or long, and only Bernstein sees even slight opportunity with U.S. stocks. The trio is cheerier about foreign developed-markets stocks, but at 3.2%, its average forecast remains modest.

Many years to navigate, with (it appears) punk returns on the horizon. What's an investor to do?

Kapito's article emphasizes investment solutions, such as including more alternative assets and adopting a goal-based approach to investing. While those are not bad ideas, they are neither sufficient nor, I would argue, particularly critical. I have four, more-basic suggestions; for me, this problem is best addressed by the obvious.

1) Save more/retire later--prosaic and unappealing, but undeniably effective.
Of the two options, high savings is more reliable. The idea of delayed retirement is currently fashionable, with proposals to hike the ages for Social Security eligibility. However, it is unrealistic as a mass solution. Although some workers will remain desirable to employers throughout their 60s, most will lack either the health or job skills. In an era of surplus labor, with many companies pushing older workers off their payroll, unwanted early retirement is as likely as delayed retirement.

Thus, higher savings. That is most easily achieved by full participation in a defined-contribution plan, beginning early in the career and quickly ratcheting up to the maximum contribution level. While individual situations do vary, the blend of Social Security and 40 years' worth of determined defined-contribution investing makes for a potent brew. The median income for retirees during the "good old days" of defined-benefit plans was never as high as what that combination will bring.

2) Lower fees--another simple idea, and less painful to do. Miniature investment returns require miniature fees. And indeed, costs have dramatically declined over the years for some investment services. Brokerage fees plummeted first, then in recent years mutual fund (and exchange-traded fund) inflows followed suit, moving heavily into the cheapest funds. Investors have never been so aware of the eroding effects of costs as they are today.

However, much work remains. Although new flows have rewarded low-cost providers, trillions of dollars of legacy assets remain in expensive funds. Similarly, while 401(k) costs are declining, particularly with larger plans, many still offer funds with expense ratios exceeding 1%--a pound of flesh, given the low expectation for real returns. The advice model, too, can and should face pricing pressure.

The move toward lower fees is only beginning.

3) Diversification--moving away from the core.
Few people will have the savvy or good fortune--mostly the latter--to invest their way out of trouble. (The more realistic goal is to avoid investing one's way into trouble.) Planning for unusual gains that will bail out lower savings rates, based on the ability to select better stocks, or funds, or asset classes, is a triumph of hope over reality.

However, there's no reason not to be relatively aggressive about diversifying away from the core assets presented in this column's chart--either for the worker saving for retirement, or for the retiree who is conducting portfolio withdrawals. Always a sound idea due to basic investment principles, owning noncore securities looks to be particularly beneficial given current market prices.

Although the chart's three prognosticators expect almost nothing from core securities, save for developed-markets foreign stocks, their average forecast for emerging-markets equities is a healthy 4.9%. GMO and Research Affiliates are also enthusiastic about emerging-markets debt (Bernstein does not offer a forecast), while Bernstein favors U.S. small-value stocks. This is also Kapito's recommendation of alternative assets, about which I am less enthusiastic, as they tend to be packaged with high fees. 

Diversifying is unlikely to make or break an investor's retirement plan, but it is an easy and beneficial step.

4) Flexible withdrawal strategies.
There is an ongoing debate about the validity of the traditional advice that retirees can withdraw 4% real from their portfolios each year, on a fixed and ongoing basis. Many find that figure to be too high given today's market valuations. (I agree.) However, the discussion is largely moot. There's no reason that anybody should plan on a fixed withdrawal strategy. Adjusting to market movements by reducing spending--and therefore portfolio withdrawals--during downturns permits a higher overall withdrawal rate, with more safety.

Says Steve Utkus, head of Vanguard's Center for Retirement Research, "So many people, even financial professionals, are locked into the notion of that fixed 4% withdrawal rate. Its assumptions are unbelievably conservative." Happily, Utkus points out, few people actually behave like that once their retirement begins. They might model static, unchanging behavior, but in reality they sensibly sway with the breezes.

The good news, therefore, is that although the investment fruit might be disappointingly small, it should contain more juice than expected.  

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.