The sustainability of retirement cash flows from a portfolio depends in no small part on the returns generated by that portfolio – in particular, the real returns, given the pernicious impact of inflation over a multi-decade retirement.
In today’s high-valuation environment, many retirement projections are being done with reduced long-term return assumptions… with the caveat that while many advisors agree on the need to project lower returns, there is little agreement on how much lower it should be.
A look at the available market data suggests that realistically, it would be appropriate to reduce equity return assumptions by about 100bps (or 1 percentage point) over the next 30 years, to reflect the current valuation environment. Ironically, the reduction is not greater, because 30 years is such a long time that even if returns are bad for a period of time, there are enough subsequent years to recover as well.
In point of fact, though, it turns out that market valuation is even more predictive of 15-year returns, and that today’s high P/E ratios imply that between now and 2030, market returns could be reduced by as much as 400bps. On the other hand, because market valuations (and the associated returns) tend to move in cycles, this also implies that in the 2030s and 2040s, market returns could be as much as 400bps above the long-term average as well.
Ultimately, then, the ideal way to adjust return assumptions in a retirement plan in today’s environment may not be to reduce long-term returns at all, but instead to do projections with a “regime-based” approach to return assumptions. This would entail projecting a period of much lower returns, followed by a subsequent period of higher returns, in a manner that more accurately reflects the impact of market valuation on returns – and better accounts for the sequence-of-return risk along the way as well!