At Business Insider, Sam Ro shows with a nifty chart the Magic of Compound Interest.  Saving in your late 20's and Early 30's is the best way to fund a fruitful retirement.  Go take a look - it will be the best 5 minutes you spend today.

Kevin Spires, CFA, FRM

As 2012 comes to a close, the number of analysts making predictions about future stock market returns has multiplied faster than the number of Jos. A Bank commercials on the financial news channels.  Before I give my own predictions (in another upcoming post), I thought I would flash back to one of 2012's most memorable spats:  Jeremy Siegel vs. Bill Gross on expected returns going forward in the stock market.  It started out with Bill Gross's Cult Figures online newsletter posting which took shots at the "Siegel" constant of 6.6% real return of stocks over the long run.  In a Bloomberg TV spat, Siegel defended his number and pointed out the errors in Gross's logic and calculations....  Gross responded with Ad-hominem.

In his written piece, Gross attempts to back into the expected return on stocks by making stock market returns a function of Real GDP...

Basically saying that equity investors have stolen 3% per year over the last century plus from others - and projects stocks returns will come in at about 2% real going forward.

Siegel sticks with the actual building blocks of stock returns - where real gdp growth is just one component.  Dividend payouts and capital gains due to stock buybacks figure just as strongly in return expectations as real gdp growth.

I am going with Siegel over Gross and I expect long run (30+ years) returns of a bit below 6%.  I expect I will break down all my factors in a rough manner in another post before year end 2012.

Kevin Spires, CFA, FRM

Another way to calculate expected returns in the stock market is explored by Mark Hulbert at Marketwatch.  In his article titled, "Stocks' future returns: just 5.6% annualized,"  Hulbert explains that a variant of a model he uses "says the long-term return will be a function of just two things: the current dividend yield and real growth in earnings and dividends." 

Hulbert then goes on to actually break this down into three things which are the current dividend yield (he never actually states it in the article) the long term growth in earnings of 1.4% and expected inflation (of who knows what). According to Hulbert "These three components today add up to a nominal return of 5.6% annualized, according to Rob Arnott, founder of Research Affiliates, an investment advisory firm — or 3.4% in real terms."  In other words, the formula is roughly (because I mistate the formula by leaving out compounding):

            Future Returns = Dividend Yield + Dividend Growth Rate + Inflation

Three things to explain 10 year expected returns in the market.  This model does have some good points to recommend to the casual investor.  The first is the use of a valuation metric - dividend yield - into the calculation of future expected returns.  The second is the use of inflation - because we can't eat t-bills - in the calculation of inflation adjusted returns.  Unfortunately, there is some bad math involved in their calculations that make the prediction less accurate than it would be if it included some other factors.

I prefer the CAPE10 (popularized in Shiller's Irrational Exuberance) to dividend yields as a valuation metric.  Historically, the dividend yield and CAPE10 were closely tied together, but with the advent of modern finance in the '80s, firms started returning capital to shareholders in the form of share buybacks and the ratio of earnings paid out as dividends decreased.  The reasons are many for this change, but the main two were the lower tax rates on capital gains and the ability of an investor to defer capital gains taxes indefinitely.  These two advantages to share buybacks versus dividends have lowered the dividend payout ratio to the point where I think it is less useful as a predictor than the CAPE10.

But I digress.  The dividend yield has been useful as a predictor of future expected returns in the stock market because it has the current market level as a denominator.  Higher current valuations result in lower dividend yields and vice-versa.  Not only will the dividend yield be smaller if the current market valuation is high, but the future returns will be smaller as the market level returns to a more normal level - resulting in capital losses like we experienced in the period following the tech bubble, or capital gains like we experienced in the 1980's after the extremely low market valuations recorded after the double dip recessions to start that decade.  Because share buybacks are now such a normal way that firms return capital to investors, I don't think the dividend yield is very useful going forward - and using the dividend yield in a model like the one Hulbert uses will cause major errors in the future.

The second good feature of this method is the use of inflation to discount the return.  Investors care about making more than inflation, so explicately solving for after inflation returns is invaluable when figuring out how much a person will have to spend in the future given their current level of savings.

Finally, the use of an expected growth metric is great as well - although I think using the historical growth rate of dividends is a flawed method for the same reasons I would not use the dividend yield as an input.  According to Shiller's work, dividends paid out as a ratio of earnings are less than half what they were just 30 years ago - because firms now return earnings to investors in the form of share buybacks.  If current dividends were doubled, the long term growth rate of dividends would be much higher as well.  I prefer to relate earnings growth to the nominal gdp growth rate - both for its close historical correlation to profit growth and because it allows one to break out real gdp and inflation as seperate factors that both flow back into nominal profit growth (let's leave that to another post).  But to summerize, the back of the napkin future returns formula I use looks like this...

        10YR Future returns = Current Earnings Yield (1/CAPE10) + Real Growth in Earnings + Inflation + Mean Reversion to Fair Value Return.

...where the Mean Reversion component assumes market valuations return to fair value over the next 10 years.

In conclusion, Hulbert's article is a good, quick introduction to a simplistic method of calculating stock market returns over the next 10 years.  I think it would be fastly improved by the use of the CAPE10 in the same simplistic model versus using the dividend yield, but it is worth reading on its own merits.

-Kevin Spires

Kevin Spires, CFA, FRM

From James Picerno at the Capital Spectator blog comes one way to think about future expected returns.  In investing, if one thing is true, it is that past performance is not a good predictor of future performance.  But, the past is often prolog with good times following bad and vice-versa.  Given the current valuation and normal volatility of an asset class, it should be possible to predict long run expected returns for an asset class.

In the Expected Equilibrium Risk Premiums, jp at the Capital Spectator blog, gives a brief introduction to one method of calculaing risk premiums across the major asset classes.  According to jp (His blog handle),

"The basic idea is to reverse engineer expected risk premia by making assumptions
about the overall market’s price of risk, the volatility of each asset class and
the correlation matrix for all of the above.1 With that data in hand, we can
estimate the implied risk premia."

Picerno then does just that with the past 3 years and 10 years of data.  Implied Long Term Risk Premia are calculated that range from a minimum of 0.3% for US Investment Grade Bonds to a maximum of 11.6% for Emerging Market Equities with a weighted average of 5.3% in his Global Market Index.

Addtionally, Picerno suggests a method for tactically over/under weighting asset classes based on an investors subjective outlook for an asset class over the shorter run.  For instance, if  "After crunching the numbers, you find that DDM tells you that the stock market’s expected performance will be considerably higher than the equilibrium-based estimate for the long run ...overweight equities relative to the market weight as a device to raise your portfolio’s expected return."

Kevin Spires, CFA, FRM

Mebane Faber's paper entitled "Global Value:  Building Trading Models with the 10 Year CAPE" has been published on SSRN.  This paper is a very will written overview of one of the major tenets of my investment philosophy - that market's mean revert over longer term time periods.

In the paper, Faber breaks out 10 year return periods into different percentiles based on their starting CAPE 10.  CAPE10, popularized by Yale Professor Robert Shiller of Irrational Exuberance fame, is an average of the past 10 Years earnings divided by the current equity market index level.  Faber shows that there is a clear and powerful relationship between current valuations and average returns over the next 10 years in US and International Equity Markets. 

Faber shows that buying cheaper markets and selling richer markets leads to much better risk adjusted returns.

Periods of strong Equity Market performance lead to richer valuations and then are followed by a period of poor performance which leads to cheaper valuations.  Additionally, the current CAPE10 has been used by many market participants (including your's truly) to predict the future inflation adjusted returns of the Equity Market.

From a planning perspective, the ability to predict the range of future Equity Market returns is invaluable when putting together an asset allocation to meet future spending needs.

Kevin Spires, CFA, FRM

If Michael Kitces' site isn't on your reading list as an Investment Advisor, Financial Planner, Estate & Trusts Attorney, or as an individual curious what trends might impact your own retirement, then you probably aren't keeping up to date on trends in retirement planning.

In a post today, Kitces focus's on "Yet More Big Changes Underway in Long-Term Care Insurance Marketplace."  The whole piece is fascinating, but what stood out as especially important to savers is that low interest rates have challenged the ability of the insurers to pay benefits.  In Kitces' own words:

"The low lapse rates are further complicated by the current low interest rate environment. After all, insurance "works" because the insurance company takes in premiums, invests them for a (conservative) return, and then uses the accumulated premiums plus growth to pay future benefits. When interest rates fall from 5% to 1%, though, the 80% relative decrease in income results in far less money accumulated - especially when compounded over many years. In point of fact, this alone explains the bulk of premium increases on existing policies in recent years; the insurance companies simply don't have as much money as they expected to pay out current benefits, because the ongoing premiums have not been able to grow nearly as much as anticipated. And because the lapse rates have been so low, the insurance companies find themselves earning not only unexpectedly low and insufficient returns, but facing claims on a much larger number of policies."

Along with the actual insurance component, I like to think of Long-Term Care Insurance (LTCI) as a sort of 401K for Long Term Care.  What Kitces' doesn't mention is that the return on accumulated premiums grows tax free which is why someone might want to save for Long-Term Care with Long Term Care Insurance rather than by saving in a taxable savings vehicle like Mutual Funds or a Seperately Managed Account at an Investment Advisor. 

While tax advantaged, LTCI has a regulatory disadvantage.  Insurance regulators force LTCI providers to invest in an overly conservative manner by rating companies based on the volatility of their excess reserves which has forced insurance companies to predominantly invest in Fixed Income.  An 80% drop in interest income is not unique to the insurance industry.  All Fixed Income investors have felt the effects of financial repression imposed by the Federal Reserves zero interest rate policies.

Low lapse rates are also likely a function of the low interest rate environment.  With the return offered by competing investments dropping by 80%, the likelihood is very low that someone would switch out of LTCI that was purchase in a higher interest rate environment with a much higher expected return built into the benefit structure.

All in all, it looks like investors should look closer at other investment vehicles to fund their long term care needs and avoid the pitfalls of investing in what are predominately Fixed Income investment vehicles.

I don't consider myself to be an expert on Estate Planning - I would refer serious inquiries about Estate Planning to other professionals, but I am trying to keep abreast of changes to tax policy and different asset sheltering strategies.  Michael Kitces at the nerd's eye view blogs about 3 Estate Planning Strategies that May Die Soon.  It is pretty amazing to see the number of tax avoidance  strategies that are legal under the current tax code.  I think it is axiomatic that the higher the tax rate, the greater the number of loopholes.  But a number of these loopholes are being targeted as ways to close the huge budget deficit of the U.S. Government.

According to Kitces, at risk are "Grantor Retained Annuity Trusts (GRATs) and Intentionally Defective Grantor Trusts (IDGTs), both popular strategies to "freeze" the value of hopefully-rapidly-appreciatingassets for transfer to the next generation. In addition, the new rules on portability - currently temporary, but likely to become permanent at some point in the future - threaten the even more popular and common estate planning strategy, the bypass trust."  A must read for anyone interacting with High Net Worth individuals.

Kevin Spires, CFA, FRM

Last week, Michael Kitces at kitces.com blogged about whether is is better to use a safe withdrawal rate methodology or buy an inflation adjusted annuity to protect essential spending in retirement.  In his post "Annuities Versus Safe Withdrawal Rates: Comparing Floor/Upside Approaches," Kitces breaks down the trade offs involved in using a safe withdrawal rate strategy versus buying an annuity or TIPS or some other income asset that has a guaranteed payout rate.

Kitces takes a hypothetical retiree with $1 million in assets who needs to fund $25,000 a year in expenses above what Social Security will pay and runs through the alternative scenarios of buying an annuity and using a safe withdrawal rate strategy.  During his exposition on the numbers, Kitces states "both produce roughly comparable floor amounts, but the safe withdrawal rate approach doesn't surrender liquidity and control, and retains what in reality is a high probability of something between a substantial and very substantial upside (compared to an annuity approach that guarantees nothing of the annuity's value will be left and no upside can be enjoyed)."

Makes you wonder - doesn't it?  Would you rather have an insurance company guarantee or potentially have $2.5 Million to leave to your family and friends through your estate?

Disclaimer:

This information is neither an offer to sell nor a solicitation to buy securities. Forecasts, estimates and opinions stated are my own and the data presented is for educational purposes only.  Investments involve risk unless otherwise stated. Past performance is not a guarantee of future results. Be sure to first consult with a qualified tax and/or financial adviser before implementing any strategy discussed.

In an article last fall, Todd Tresidder of FinancialMentor.com asks "Are Safe Withdrawal Rates Really Safe?"  In this broad ranging article Todd covers 6 main topics:

1.)  What are safe withdrawal rates and why are they important.
2.)  A review of the three different "generations" of research about safe withdrawal rates.
3.)  The importance of taking into account market valuations when setting safe withdrawal rates.
4.)  The importance of the sequence of returns in the first few years of retirement on safe withdrawal rates.
5.)  The negative impact of inflation on safe withdrawals rates.
6.)  A better process to follow when setting expectations for retirement spending.

Following along the same path as Todd, I have developed a process to simulate the future safe withdrawal rates given current market values, inflation, and a whole range of other factors.  I am also able to run this analysis 20, 30, or 40 years before retirement, in time for an investor to make meaningful changes to their investment and retirement planning.  I have published part one of Recalculating Your Retirement, in which I review what the average Nominal and Real Returns for Equities and the 10 year Treasury have been over the past 140 years.

Tell us what you think...

Kevin Spires, CFA, FRM

Kevin B. Spires, CFA, FRM

Over the long haul, Stocks tend to beat Bonds.  Using Dr. Robert Shiller's Irrational Exuberance data set, I calculate the long term returns of the S&P 500 and the 10YR Treasury over the time period of 12/31/1871 to 12/31/2011 - a total of 140 years.  Click on the full piece...

Why would one do such a thing as calculate historical returns?  With apologies to Mark Twain... While history may not repeat itself, it often rhymes.  Past Returns can be an important guide in determining the range of possibilities for future returns.  Over what promises to be a lengthy series of research pieces, I will tease out the most important components of future returns by decomposing historical returns.  In this first part, I will just present what those historical returns have been.