The average US public pension plan (similar in Canada) is assuming it will net an average 7.4% annually going forward. Even on that rosy presumption, the average pension today has a 27% capital shortfall and 73% of the assets needed to fund payouts promised to retirees. To meet planned withdrawals, most retirement plans–pensions and individuals–need to do some or all of the following:
- increase contributions
- reduce planned withdrawals
- defer the start age for withdrawals
- cut expenses and overhead
- net significantly more than 7.4% a year on savings invested
The first four options are wildly unpopular. The last is highly unlikely. Most people are banking on improbable returns anyway. As I recently explained in High fees and risky bets, not in best interests of Canadians this opens up the likelihood of financial disappointment and hardship later in life, when fixes and time to recover are hard to come by.
As the WSJ explains in America’s public pensions are stuck in the clouds, the rise in asset prices since 1987 has been unusually high by historical averages, and that means returns from present levels are set to be lower than average. To wit: in 1987 a 30-year government bond yielded nearly 9%, and stocks were moving off a 20-year low in valuations in 1982 that started from single-digit multiples and dividend yields north of 8%.
Today, 30-year treasuries are yielding 1.7% in Canada and 2.6% in the US, and stock and real estate valuations are at the very top of historical occurrences. Just one example: the Shiller cyclically-adjusted price-to-earnings ratio (CAPE) which has proven one of the best predictors of medium-term stock returns, is above 30 today compared with 16 at the end of 1987. This matters. Historically when the CAPE has been above 25, subsequent stock returns have averaged 4.1% a year assuming no fees or withdrawals of any kind were taken along the way, and every dividend was reinvested. Since this is rarely, if ever, possible, real-life compound returns averaged much less than 4.1%.
The reality is that based on presently elevated security prices, a portfolio aggressively allocated 70% to equities and 30% to corporate bonds might be expected to gain 3.8% gross per year over the next decade–again assuming no fees or withdrawals to detract from compound growth are taken. Anyone trying to withdraw income from this portfolio would underperform the hypothetical 3.8% return target significantly while having to hold through steep bear markets and wait many years for principle to recover in between. Most, at or near retirement, will not be able to do any of this.
We have to make our financial decisions based on the real-time facts and probabilities at hand. Holding stocks and corporate bonds (or funds of them) today with the capital we will need to fund retirement or other needs within the next ten years is a volatile, high-risk, and poor-return prospects plan.
Minimizing exposure to extremely over-valued assets today and keeping principle secure and liquid so that we can buy after they’ve repriced to the lower end of historical ranges once more, makes reaching financial goals not only possible but probable.
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