Thursday, June 28, 2012

Retirement Planning In A World of Low Returns

In an interview in Money magazine last month, famed Yale economist Robert Shiller gave a long term outlook for stocks for the next few years:

You have become famous for your cyclically adjusted 10-year price/earnings ratio. What do the latest numbers say about future stock market returns? 

When my former student and I did the original analysis -- I was working with John Campbell, now economics department chairman at Harvard -- we found a correlation between that ratio and the next 10 years' return. 

If you plug in today's P/E of about 22, it would be predicting something like an annualized 4% return after inflation. Not so bad when you look at the 20-year Treasury bond yield of 2.8% and the likely capital losses if interest rates go up.

Shiller goes on to say that risks are probably more skewed to the downside - that is, stocks return less than 4% - than upside possibilities, mostly because of today's economic backdrop.

That said, it seems to me that earning a 4% real return from stocks is actually not all that bad when you consider that high quality bonds are currently yielding less than today's inflation rate (i.e., negative real returns).

So in terms of retirement planning, then, it seems logical that common stocks should continue to play an important role in investors' portfolios.

It makes even more sense to emphasize stocks over bonds when you try to figure out how much it will take to maintain your current lifestyle.

The New York Times this morning had a short piece on retirement planning.  Quoting a study by retirement consultant Aon Hewitt, here's what they figure a new retiree needs:

Eleven times your final working salary.

That’s how much an average worker needs beyond Social Security payments, from sources like personal savings and employer benefits, to pay for retirement at age 65, a new analysis from the benefits consultant Aon Hewitt finds. The estimate takes into account inflation and post-retirement medical costs. And it is based on the retiree continuing to maintain the same standard of living.

Delaying retirement to age 67 reduces the amount to 9.4 times pay, while retiring earlier, at age 62, increases it to 13.5 times pay, the report said.

This seems to me to be reasonable number, but fairly daunting number, especially given the fact that the real wage growth for most workers over the past decade has been negligible.