The U.S. stock market is trading at worrying levels while political uncertainty is disrupting world trade.TIMOTHY A. CLARY/AFP/Getty Images
School is back in session, but the hard lessons might be learned by investors on the cusp of retirement. They’re facing peril from a combination of the unusually lofty U.S. stock market and political uncertainty that’s disrupting world trade.
Planning for retirement is tricky at the best of times because it is beset by uncertainties both known and unknowable. High valuations are one of the known problems but that doesn’t make them easy to deal with.
The U.S. stock market is trading at worrying levels based on a variety of value factors. For instance, the S&P 500 Index is trading at a cyclically adjusted price-to-earnings ratio (developed by Robert Shiller) near 39, which is above its peak of 33 in 1929 and it is approaching its top of 44 in late 1999, based on monthly data. Similarly the index’s price-to-sales ratio is approaching its 1999 high. A broader composite measure that includes many different market factors indicates that the U.S. market’s valuation is at record levels.
While valuation tends to be a poor near-term market predictor, it has done a pretty good job over the long term and the signs aren’t good. As things stand, it seems likely that the U.S. stock market will generate unusually poor average real returns over the next decade or so.
A bad return streak early in retirement is known as an example of sequence of returns risk and it’s the stuff of retirement nightmares. For instance, those retiring in the early 1970s suffered from the crash of 1973, stagflation, and then the recession of the early 1980s, which exhausted many portfolios before the good times returned for much of the 1980s and 1990s.
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The investigation of past crashes led to what’s known as the “4-per-cent rule,” thanks to the work of William P. Bengen. He was interested in the maximum initial withdrawal rate (subsequently adjusted for inflation) that a U.S. retiree could spend from a balanced portfolio over a 30-year period without running out of money based on U.S. market history. His study was published in 1994 and a 4-per-cent withdrawal rate allowed the portfolio to survive the crash of 1929 and the stagflation of the 1970s.
Mr. Bengen recently published a new book on the topic called A Richer Retirement: Supercharging the 4% Rule to Spend More and Enjoy More where he discusses the possibility of boosting the withdrawal rate depending on the circumstances.
The U.S. stock market has been one of the world’s top performing markets since 1900 as the country became a pre-eminent world power, which makes it unusual. It’s wise to also consider the broader international experience because the 4-per-cent rule proved to be overly optimistic when applied to international stocks. It’s one reason why PWL Capital’s Ben Felix suggests that an initial retirement withdrawal rate somewhere between 2 and 3 per cent, depending on the circumstances, is more reasonable than 4 per cent.
Alas, given the political situation stateside, investors should worry about problems that were once thought to be unlikely or even virtual impossibilities as the country transforms itself. The consequences might result in extreme behaviour from the markets – or much worse.
To compound matters, the U.S. stock market represents about 65 per cent of the world’s market by market capitalization based on its weight in the MSCI All-Country World Index at the end of August.
If the U.S. stock market flops, it’ll likely take the rest of the world with it – at least temporarily.
Despite the presence of risks that cannot be ameliorated, planning for retirement has its uses because it can help investors avoid common pitfalls and problems. But retirement plans have to be updated regularly and when material changes occur.
Adaptability is a big reason why retirees should consider adopting variable withdrawal strategies, like the “variable percentage withdrawal” method suggested by Prof. Étienne Gagnon, where the withdrawal rate is updated over time.
Simple changes – like doing a little belt-tightening during downturns – can also help improve a portfolio’s survival probability.
Given the state of the U.S. market, retirees would be wise to save more than the bare minimum before retiring so that they have an adequate margin of safety with which to withstand setbacks and unexpected problems. Those who save too much won’t get to enjoy spending every penny in their lifetimes but it’s better than the alternative.
Others might reject the idea of retirement and soldier on with their productive lives – or take on the odd part-time job – for as long as their health permits.
Unfortunately, investors on the cusp of retirement should be prepared for the possibility of unusually hard times over the next several years and some difficult lessons likely lie in store for all of us. Good luck out there.
Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.
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