The Low Return Imperative
Investors are grappling with the potential that — after seeing strong returns for both equities and bonds following the 2008 financial crisis — future returns are likely to be lower. The current bull market in equities is the longest on record, now entering its eighth year. Investors are torn between caution due to the extended market gains and optimism as global economies pick up momentum. Growth, inflation and policy are diverging among different regions globally, creating the potential for financial market volatility.
Demographic trends indicate that Canadians are living longer and will therefore probably spend a longer time in retirement – and that in turn means an investment portfolio will need to maintain its purchasing power for longer than ever before.
The probability of lower returns and longer lives has a direct impact on the ability of investors to reach their desired investment outcomes. Many investors are likely to aim for a certain income replacement percentage at retirement to supplement government-funded programs such as the Canada Pension Plan or Quebec Pension Plan. In many cases, the required return or “hurdle rate” will be 2%-4% above what is likely to be delivered by the markets.
Source: BNY Mellon, Russell Investments. Historical based on 20 years annualized returns as of 12/31/2016, 60% S&P/TSX Composite Index and 40% FTSE TMX Canada Universe Index. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Forecasts based on capital market assumptions as of December 2016 for the next 10 years. Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. There is no guarantee that any stated results will occur.
According to Russell Investments’ 2016 Capital Market assumptions, the 60% equity / 40% bond “traditional” balanced portfolio is expected to produce potential returns of 4.6% annually for the next 10 years - well below the 6.9% annual returns such a portfolio has produced over the past two decades.
This disjunction means many investors may not only need to change their return expectations, but also the way many of them invest.
Maintaining Sustainable Retirement Income
For those investors who need their portfolio to provide a sustainable income throughout retirement, the potential of a low-return outlook or market correction also raises the possibility they could face future shortfalls. With life expectancy in Canada now at 82 years (and continuing to rise according to the World Bank), many Canadian investors will need their portfolios to provide a retirement income for 20 or even 30 years.
As we can see in the chart below, over the next 10 years, the traditional asset classes in a typical Canadian balanced portfolio are expected to produce returns well below the “hurdle rate” of 5%-7% annually that would allow investors to obtain a sustainable income while preserving their capital. To reach that level of return potential, investors may need to consider adding U.S., global, and emerging markets equities, as well as non-traditional asset classes, such as global infrastructure and global real estate.
Required Returns Haven’t Changed
Not only do investors typically need high single-digit investment returns in their retirement portfolio to meet their financial goals, many also hope to preserve their portfolio’s principal in real terms. Today’s investing environment, with high equity valuations and a challenging fixed-income market, ongoing volatility and heightened geopolitical uncertainty, means there is also greater risk of significant drawdowns or market declines.
Source: Russell Investments December 2016 Capital Market Assumptions
*Please note all information shown is based on assumptions. Expected returns employ proprietary projections of the returns of each asset class. We estimate the performance of an asset class or strategy by analyzing current economic and market conditions and historical market trends. It is likely that actual returns will vary considerably from these assumptions, even for a number of years. References to future returns for either asset allocation strategies or asset classes are not promises or even estimates of actual returns a client portfolio may achieve. The assumptions do not take fees into consideration and all returns are assumed gross of fees. Asset classes are broad general categories which may or may not correspond well to specific products.
Russell Investments research has found that the traditional 60% equity/40% fixed income balanced allocation had a 70% chance historically (1938-2016) of maintaining a 4% spending rate without depleting principal, allowing investors to obtain a regular source of income throughout retirement. Now, the expected probability a similar balanced allocation could maintain real purchasing power with a 4% spending rate has dropped to 34%.
This reality highlights the increased importance of downside risk management. To understand why limiting drawdowns on a portfolio’s principal is important, consider the value of compounding. When markets are positive, the value of compounding means that each year’s gains build upon the previous year’s. The same principle applies during poor markets, but in reverse. And more importantly, any loss requires a much larger gain to return to break-even.
Multi-Asset: A Potential Solution For A Lower Return Environment
There are a variety of ways to solve the problem of the ‘low return imperative’ (or at least lessen its impact). Some of these solutions may involve changes in behaviors rather than investment solutions – saving more, or spending less. Some investors may not achieve the outcomes they expect unless they find additional sources of return.
A multi-asset investment solution aims to increase the probability of achieving a specified outcome over the long term by accessing return sources and opportunities that may not be available in a traditional 60/40 balanced portfolio.
Multi-asset solutions typically include both traditional and non-traditional diversifying assets (such as Global Infrastructure and Real Estate) to maximize asset class, geographic, sector, and factor diversification. Multi-asset portfolios are managed dynamically in real time and are designed to help hedge portfolios during market downturns while potentially participating in the upside.
Source: Russell Investments, Based on the historical 10-year rolling inflation-adjusted annualized returns from 1938-2016. Equity: 1/3 Canadian Equity, 2/3 Global Equity. Bond: 100% Canadian Fixed Income1. Index performance is not indicative of the performance of any specific investment. Indexes are not managed and may not be invested in directly.
The search for returns in today’s low-return environment is real and presents investors, and their advisors, with critical decisions. A multi-asset approach is one way that investors can attempt to face the challenge of lower returns and increase their probability of a longer, sustainable retirement.
1Canadian Equity = S&P/TSX Composite Index; Global Equity = S&P 500 (1938-1969), MSCI World (1970-1980), MSCI World ex Canada (1981-2016); Canadian Fixed Income = FTSE TMX Canada Long Term Bond (1938-1979), FTSE TMX Canada Universe Bonds (1980-2016)