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Are Current Return Assumptions Achievable?

You created a financial or retirement plan and are excited to see your plan projects a high probability of success. An important part of your plan is the estimate of future returns. When measuring success, we consider three variations.

The first is the use of “average return” where we assume the same return every year.

Next, we consider “bad timing” which is similar in that we assume constant portfolio returns every year EXCEPT the two most dangerous years…the first two years of retirement.

Finally, we measure how many trials would be successful using variable returns (Monte Carlo scenario). When considering returns, we can focus on nominal (gross) or real (inflation adjusted).

 Let's Get Real?

During plan reviews, I tend to focus on the expected real return of the portfolio rather than the nominal return. When considering real return, we measure the return ABOVE inflation. Nominal return is the return you see on statements. No matter how much I focus on real returns, I know it is difficult to ignore nominal returns.

When building your plan, we included a default inflation adjustment by which your expenses and goals increase throughout your plan. In some cases, we use a higher rate (college education and medical) while for others we use a lesser increase (pensions, autos).

For your plan to project success, your investments and income must produce a return (growth and income) that overcomes the increased cost of goals and expenses. In other words, we focus on the return above inflation. As an example, if we consider projected returns of a 60% stock portfolio (60/40), we are currently projecting a nominal return of 5.81%. With a 2.5% inflation assumption, we are assuming a 3.31% REAL return.

 Emotions and history

I often hear how great it would be if would be if we could earn 4% in money markets again. Or, some reminisce about a period where bonds (and money markets) were paying double digits. They tend to forget the $4-dollar gallon of gas…

The periods in question had higher inflation rates than we are experiencing today. The point…if prices are increasing by 10% and you are earning 10% in a money market, are you really any better off than when you are earning 1% and prices are increasing at 1%? I argue no. It just feels better when your statement reveals the (nominal) return of 10%.

For the past 8 years, low interest rates have negatively affected nominal returns. But, inflation has been low as well which has limited the increase in cost of goods (with some exceptions). Who thought we would be paying less than $2 for a gallon of gas (currently slightly higher)?

If we were in a period of double digit inflation, we wouldn’t use a projected return of 5.81% return for a 60/40 portfolio because 40% of the portfolio would likely be earning double digit returns. I hope that makes sense. If you have questions, please let me know.

 Accurate estimate?

When reviewing the details of your plan, one of the unknown inputs is investment earnings. A common question during review is whether the current assumption is achievable. Given the frequency of the question, I decided to review the historical tradeoff between inflation and nominal returns.

First, let’s look at the Consumer Price Index (CPI) data which measures inflation. I took all data Dimensional Fund Advisor’s (DFA) Matrix book (2016 version – data includes 2015). I chose to look at periods greater than one year, but share the outliers later in the post.

CPI was 1.2% for trailing 3 years; 1.5% trailing 5; 2.0% trailing 10; 2.2% trailing 20.

Next, I considered the returns for various allocations (again from DFA Matrix book). A portfolio with 60% allocated to stocks (60/40) had a nominal return of 6.1% trailing 3 years; 3.9% trailing 5 years; 5.4% trailing 10 years; 7.8% trailing 20 years.

Finally, I considered real returns (nominal return minus inflation) for the same periods. Real returns were 4.9% for the trailing 3 year; 3.9% for 5; 3.4% for 10; 5.6% for trailing 20.

We are currently using an estimate of 5.81% nominal return for a similar portfolio with a 2.5% base inflation estimate or a 3.31% real return assumption. Based on history, this seems to be a good estimate.

I followed a similar process for other allocations. I won’t bore you with all the details, but rather give you the Clif Note version. A 20/80 allocation had real returns of 1.3% (3 year); 1% (5 Year); 1.6% (10 Year); 3% (20 Year). Our current assumption for a 30/70 (DFA doesn’t provide data for 30/70) is a nominal return of 4.42% or 1.92% real return. This number also seems fair given a little more risk and the artificially low (but rising) interest rates.

A 40/60 portfolio had real returns of 4.3% (3 Year); 4.0% (5 Year); 4.6% (10 Year); 6.5% (20 Year). Again, not a perfect comparison, but when considering a portfolio of 45% stocks and 55% bonds, we use an assumption of 5.10% nominal with a 2.5% inflation assumption or 2.6% real return. Again…in line.

 Going to extreme

When projecting plan success, we should be using an average or rolling period rather than one year figures, but I thought it would be interesting to share some of the extremes.

 I start with periods of high inflation. In 1974, CPI was reported at 12.3%; 1980 13.3%; and 1979 13.3%.

  • In 1974, the S&P 500 Index lost 26.5%. DFA Small Cap Index lost 27.1% while one month T-Bill (arguably what you could earn in a money market) returned 8.0%.
  • In 1979, the S&P 500 Index gained 18.4%. DFA Small Cap Index gained 22.1% while one month T-Bill returned 10.4%.
  • In 1980, the S&P 500 Index gained 21.4%. DFA Small Cap Index gained 37.9% while one month T-Bill returned 11.2%.

 When considering low CPI figures, history reveals low measurements of 0% in both 2014 and 2015. The next lowest in recent history was 1.6% in 2008.

  • In 2008, the S&P 500 Index lost 37.0%. DFA Small Cap Index lost 35.9% while one month T-Bill returned 1.6%.
  • In 2014, the S&P 500 Index gained 13.7%. DFA Small Cap Index gained 3.8% while one month T-Bill returned 0%.
  • In 2015, the S&P 500 Index gained 1.4%. DFA Small Cap Index lost 5.6% while one month T-Bill returned 0%.

 An interesting revelation is that the one-month T-Bill has not managed to equal or outperform the CPI Index since 1998. But, prior to 1998, the one month T-Bill equaled or outperformed the CPI every year back to 1934! My initial thought as I saw this was…have we been willing to accept market risk at the cost of safety since 1998? Of course, as always, there are other factors to consider.

An average week

Steph “needed” to get fake eyelashes for her next performance at the theater. Why did she “need” them? Simple…her double wore them. At ten years, old that’s all it takes to define need. “Shouldn’t you have mom take you for eyelashes?” No. You’ll do. “Gee. Thanks.”

We stop at Walgreens and head down the makeup aisle. She proceeds with a quiz. “Hey Dad, what is that?” I got lip stick right…the rest…well, not so much. Sometimes I wonder why I entertain her games. Oh yeah…because she entertains mine.

An employee watched the “makeup test” with amusement. We finally found the fake lashes and were moving on. The amused employee asked (with a chuckle) if there was anything she could get for me. My quick (and well timed in my opinion) answer…” how about a new daughter?” The employee broke out in laughter. Stephanie…” You know I can hear you, right? Love you too dad.” If she wants to quiz me on makeup products, wise cracks are fair game! In other words, an average week.

This weekend was full of performances. A school performance on Friday, her Saturday performance at Desert Stages and while I write this (Sunday), she is at Gammage Auditorium with her mom. The girl likes her theater, which of course is not a bad thing. Subjecting your dad to a makeup quiz…different story.

 Lesson learned…next time…here is $20. I’ll wait in the car.

Looking Forward

Hopefully, this post helps us all understand one of the unknown inputs in your plan creation. It is important to understand the inputs and the rationale underlying your plan’s output. If you don’t agree with the inputs and assumptions, you won’t be comfortable moving forward with recommendations…enjoying your life!

I often say, “financial planning is a process rather than an event.” The review of return assumptions is a good example of this mantra. As you saw, there are extreme periods which tend to revert to the long-term mean given some time. Your plan is not based on extremes. It is based on a long-term projection. We know most of the assumptions in your plan will be incorrect at some level.

 Pilots and surgeons

You may have heard that airplanes are off course most (stories usually include a high percentage) of the time. The pilot, controller and I suppose computers make small changes throughout the flight so you end up at your destination even if the plane was off course most of the time. I heard a similar story while waiting for Steph’s school performance (from Steph’s boyfriend’s dad – that is an entirely different topic).

He shared that MOST surgeries do not go perfectly. We don’t want to hear that, but…

He pointed out how few projects went exactly as planned. Think about your last home improvement project. Any extra trips to Home Depot or Lowes? Did you need to unscrew a bolt and redo? His point was well taken.

Even when we are well trained in one specific field or task, we aren’t perfect and there are factors that affect the outcome no matter how much preparation was made. This is true for financial planning as well. We know there will be extremes (both positive and negative). Like the surgeon or pilot, we begin with a proven process and rely upon our skills and logic to make necessary changes.

When building or reviewing a financial plan, there are factors we know with certainty, others with less certainty and finally ones we must rely on judgement going forward. Projecting a forward-looking return falls into the final category. While we can’t predict future market returns, I hope this post provides comfort in knowing we are using a future return that is based on more than a guess…an educated guess.

 If you have questions about anything other than make up or Steph’s boyfriend, please let me know. I can’t answer the first and choose to ignore the second.

Hi. I write and distribute a letter like this one every week. In the letter, I share thoughts about financial planning and often include opinions or experiences from my 10-year old daughter...Stephanie. If you would like to be added to the distribution list (I am sure you don't get enough emails already)...please send me your email address. I will happily add you. Thanks. 

Email: bob@disciplinedmoney.com

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