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A version of this article appeared on Oct. 16, 2020.
Retirees want income, and if they're looking for it from bonds, they're not going to get very far. The 10-year Treasury is currently yielding just 1.3%, and every bit of that could be eaten up by inflation. That lack of return potential puts pressure on withdrawal rates, especially for retirees just starting out, and also underscores the importance of maximizing nonportfolio income sources such as Social Security and annuities.
But what about equities? The picture there may not be as obviously dire but neither is it especially positive. That's because valuations have historically been one of the better guides to future market performance, and valuations on broad U.S. market-cap-weighted benchmarks aren't cheap today. The cyclically adjusted Shiller P/E ratio, for example, recently scraped 39, its highest level since the late 1990s/early 2000 period.
Of course, the Shiller P/E has looked lofty for quite some time, and yet stocks have continued their upward march. Nonetheless, few of the firms that produce capital markets forecasts, whether BlackRock, Vanguard, or Research Affiliates are expecting great returns from U.S. equities over the next decade.
The prospect of a 10-year stretch of weak equity market returns shouldn't be a great concern for people who are many years from retirement. Sure, you may wish to adjust your return expectations downward a bit to account for a potentially weak next decade, but that shouldn't materially affect how you save and allocate your portfolio.
But what if you're getting close to retirement or are already retired? In that case, high equity valuations are more significant. Here are some of the implications to bear in mind when thinking about what they could mean for your plan.
Implications for Asset Allocation and Glide Path High equity valuations have implications for the asset allocation of in-retirement portfolios, as well as how that asset allocation might change over time.
In the traditional "glide path" for retirement portfolios, the retiree begins retirement with relatively more in aggressive assets. As retirement progresses, her allocation to safer assets--cash and fixed income--ramps up. The idea is that as the retiree begins to consume her portfolio, she'll want to lock down more of it in safe assets.
However, lofty equity valuations make a good case for retirees starting out with a lower equity weighting. That's because sequencing risk is of most concern for new retirees. By starting out with more conservative portfolios, new retirees have a buffer of safe, nonequity assets that they can spend through as retirement progresses. That's the "reverse glide path" idea that Michael Kitces and Wade Pfau advanced several years ago.
This approach is actually quite similar to a Bucket strategy. The basic idea of bucketing is that you're building yourself a runway of safe assets--cash and bonds--to spend in the earliest years of retirement. (My Model Bucket Portfolios feature 10 years' worth of portfolio withdrawals in cash and bonds for that reason.) What I like about that setup is the optionality. If the stock market continues to perform well, the new retiree can subsist, at least in part, on the appreciation from the equity holdings. But if stocks slide, as high valuations suggest they could at some point, the retiree can use cash and bond holdings to meet living expenses.
The big downside of the bucket approach is that the return potential of the cash and bond sleeve is ultralow today--possibly even negative over the next decade. That underscores the importance of not overallocating to safe assets. Retirement researcher Pfau has also suggested that retirees consider other "buffer" assets in lieu of cash: standby reverse mortgages and life insurance cash value, for example. All of these options carry their own caveats, but their main benefit is that they can be tapped "on demand" versus acting as a persistent drag on the portfolio.
Implications for Intra-Asset-Class Positioning Minding asset allocation and glide path is one of the key ways that retirees and pre-retirees can contend with a potentially tricky equity market in the years ahead. But retirees concerned about sequencing risk might also take a look at the complexion of their equity holdings. That's because one feature of the current bull market, at least until very recently, has been the dominance of a handful of names at the top of the U.S. market and the relative underperformance of the rest.
As U.S. market strategist Dave Sekera noted in a recent article, value stocks still look undervalued relative to growth. Additionally, most asset managers' capital markets forecasts also suggest that foreign stock returns are also likely to be better than those in the United States over the next 10 years, largely because of relatively better valuations on non-U.S. names.
Of course, what's most attractively valued won't necessarily outperform in a broad market sell-off: In 2020's first-quarter market shock, and before that in the 2007-09 financial crisis, value stocks, which tend to be more cyclical in nature, lost more than the broad market. In other words, if you're concerned that stocks are overvalued and could be due for a fall, don't look to value and/or foreign stocks to save you. Exposure to safer asset classes is the only reliable hedge in that instance. Nonetheless, retirees and pre-retirees can arguably improve their portfolios' return potential over a full market cycle by ensuring that they at least have some exposure to these undervalued areas. If you're conducting year-end rebalancing, be sure to assess your portfolio's intra-equity exposures as well as your baseline asset allocations.
Implications for Withdrawal Rates In addition to taking a close look at your asset-class and intra-asset-class exposures, one of the best ways to gird your retirement portfolio against the risks of high equity valuations is to stay flexible on withdrawals. Much of the research around retirement-portfolio withdrawals points to too-high withdrawals in periods of market duress as contributing to shortfalls later on.
This is of particular concern to new retirees, and much less so for people who have already been retired 15 years or more and thus have a shorter remaining time horizon in retirement. If new retirees can make do with less in weak market environments, that leaves more of the portfolio in place to repair itself when the market eventually recovers.
There are a number of strategies to tether your portfolio withdrawals to market conditions. Pfau discussed some of the key methods in our interview with him, and financial advisor Jonathan Guyton has also been a thought leader in this area. Karsten Jeske's research aims to be more forward-looking, using market valuations to guide portfolio withdrawals.
Implications for Return Expectations Troubleshooting sequence-of-return risk through thoughtful asset allocation and withdrawal strategies is crucial in a period of not-cheap equity valuations. But even if you lay a plan to avoid spending from equity assets if a bear market happens to occur early in your retirement, the prospect of meager returns from stocks will also have implications for the totality of your plan.
How much help can you expect from stocks over your retirement time horizon? That's not just an academic question. Without some expectation of what the major asset classes--and in turn your portfolio--are apt to return, you won't have any sense of how much you can safely withdraw without running out early.
Many investors use returns of 8%-10%--in line with market history--when creating their financial plans. That's not crazy for investors with very long time horizons of 20 or 30 years to retirement, though even they may wish to give market returns a bit of a haircut to account for high starting valuations.
Reducing returns assumptions is even more important for people with shorter time horizons--those who are already retired or plan to retire within the next decade. Once drawdown commences, there's simply less room for error in the plan, and most retirees would rather be safe and assume too little help from the market than overestimate the market's return and risk running out. Moreover, a bad decade will be a bigger percentage of their total time horizon. For someone embarking on retirement with a 30-year time horizon, for example, a 10-year weak stretch would be a third of their total time horizon. If we assume a 3% return for stocks over the next decade and 8% in each of the decades thereafter, that works out to be a roughly 6% return over the 30-year time horizon. Of course, there are more sophisticated ways to project returns, but the bottom line is that high equity valuations would suggest making conservative assumptions about your portfolio's equity returns, especially if your time horizon is fairly short.