Can Investors Still Rely on 7% to 8% Annual Returns
The average annual inflation-adjusted return of the S&P 500 between 1928 and 2015 has been about 8.5%, but – as the fine print always reads – past performance isn’t a guarantee of future performance. In other words, investors should necessarily rely on a long-term average when calculating how much they need to save or invest for the future. In fact, some analysts believe that the performance over the past two decades may have been an anomaly.
In this article, we will take a look at whether or not investors can still rely on the commonly cited 7% to 8% annual returns when planning for their future.
Potential for Lower Returns
McKinsey & Company’s Diminishing Returns: Why Investors May Need to Lower Their Expectations contends that the forces that have driven exceptional investment returns over the past 30 years are weakening and even reversing. Inflation and interest rates fell sharply from their peaks, global economic growth was strong, favorable demographic trends were in place, and technology dramatically boosted productivity across advanced economies.
With growth slowing and interest rates chronically low, the report suggests that U.S. equity returns could fall as low as 4%, U.S. government bond yields could approach zero, European equities could average just 4.5%, and European government bond yields could approach zero – as they already have in some regions. Under a growth-recovery scenario, the report suggests returns could be modestly higher, but still well below the 20-year average.
These lower returns could have a profound impact on individual and institutional investors around the world. For example, the report points out that a 2% difference in average annual returns over an extended period would mean that a 30-year-old today would have to work seven years longer – or almost double their savings – to live as well in retirement. Public pension funds would also have to adjust their expectations or reduce payouts.
Catalysts for Higher Returns
McKinsey & Company’s report highlights some important risk factors that could translate to lower returns over the coming years, but there are other analysts who believe that the future could be a lot brighter as emerging markets grow and new technologies evolve. While these views are often based on future expectations versus past performance, the impact of technology in the 2000s has been undeniable.
Technological disruption beyond the levels anyone envisions today could accelerate gross domestic product (“GDP”) growth in the future. For example, the evolution and application of machine learning and artificial intelligence across a multitude of industries could make workers significantly more productive in advanced economies. According to Analysis Group, artificial intelligence could have a $5.89 trillion impact on the global economy over the next 10 years.
Many emerging and frontier markets are also ripe for out-sized growth over the coming years if they modernize and mature. While China has been a clear catalyst for growth over the past several decades, the favorable demographics in India and Pakistan could drive further growth and innovation outside of the developed world. According to EY, emerging markets could account for 50% of global GDP and 55% of fixed capital investment by 2020.
Securing a Portfolio for the Future
International investors take both of these viewpoints into account when building and maintaining their portfolios for the future.
The first takeaway is that lower returns are likely given past performance, which means investors should certainly adjust their expectations accordingly. This could potentially mean planning to invest more capital early on to generate the same returns later in life or delaying retirement to enable more years of in the market. While the move may be painful in the short-term, the potential benefit of having enough for retirement down the road is worth the effort.
The second takeaway is that investors may need to look beyond traditional markets and asset classes for the best growth opportunities. For example, international investors might look to increase their emerging market exposure over the coming years as they become less risky and offer compelling returns compared to developed markets. It may also be necessary to reduce bond exposure and potentially increase exposure to the technology sector.
The Bottom Line
Individual investors have been told to plan on annual returns in the 7% to 8% range when planning for retirement, but these kinds of returns may be less likely over the coming decades, according to a report by McKinsey & Company. While new technological breakthroughs could change these predictions, investors should plan for the worst and hope for the best in order to properly manage their finances and ensure a timely and well-funded retirement.