Don’t Rely on Portfolio Backtesting
Some of the most popular “retirement calculators” on the internet use past investment performance to let users backtest the resiliency of their portfolio and withdrawal strategy. On the surface, this seems like a great idea. If your current plan would have survived the ups and downs of 100+ years of market performance, surely you’re in the clear, right?
Unfortunately, things aren’t that simple.
It varies depending on the measurement period, but historically, the nominal compound average annual return for stocks and bonds is around 10% and 5%, respectively. With a traditional 60/40 (stock/bond) allocation, prior expected returns for a balanced portfolio comes to a nice, round 8.0% per year. With historical numbers like this, it’s easy to see why an inflation-adjusted 4% safe withdrawal rate (SWR)—made famous by the Trinity study from 1990s—seems like a reasonable, if not conservative, strategy for drawing down your portfolio in retirement.
But here’s the problem. Today, the consensus among experts is that, compared to historical averages, folks should prepare for considerably lower investment returns for the foreseeable future. Interest rates are hovering near all-time lows, and bonds are expected to provide income of only about one-third of their historical average. Likewise, price-to-earnings ratios for equities are at unusually high levels, which suggests that stocks could be poised to underperform relative to the past. After all, it stands to reason that the expected return on risky assets should be some combination of the return on low-risk assets (e.g., U.S. Treasury rates or Bank certificates of deposit) plus a risk “premium” to compensate investors for the additional uncertainty. So, in today’s unusually low interest rate environment, we must think carefully about the implied risk premiums required to replicate historical stock market performance to the tune of 10 to 12% annually, and whether that seems reasonable.
Three prominent industry authorities recently provided long-term (10-15 year) return projections for U.S. Stocks (large-cap) and Bonds (high-grade U.S. corporate), summarized below. In light of these forecasts, it’s easy to see why the traditional 4% withdrawal rate might no longer seem prudent or conservative.
Stocks: 3.40%
Bonds: 1.90%
60/40: 2.80%
Stocks: 6.55%
Bonds: 1.70%
60/40: 4.61%
Stocks: 5.13%
Bonds: 2.16%
60/40: 3.94%
Sources: Vanguard, Black Rock , and JP Morgan.
