The Low-Return Imperative: Investing uncomfortably

We all know that successful investing is hard, but does it seem to be getting harder? For many investors the answer is “Yes” for two primary reasons:

1. Many investors need fairly high nominal returns to achieve the investment outcomes they seek. According to a Goldman Sachs survey published in October 2015, the 50 largest U.S. defined benefit plans have assumed an average expected return of 7%. Many individual investors likely have similar return expectations built into their financial plans.
2. Market returns have lagged long-term averages over the last decade. For example, a hypothetical balanced index portfolio composed of 60% MSCI World Index/40% Bloomberg Aggregate U.S. Bond Index had a 10-year annualized return of 5.50% as of 10/31/2016. That means that, over the past 10 years, a completely passive portfolio would have been hard pressed to achieve that 7% return so many investors expect.

What does the future look like? No one can precisely predict the path markets will take. But, with major equity markets at, or near, all-time highs and interest rates around the world at historically low levels, the next 10 years are likely to be equally – and perhaps even more – challenging for many investors. As of June 30, 2016, Russell Investments’ forecasts suggest that a hypothetical 60% global equities/40% U.S. bonds portfolio may have an annualized return of 4.78% over the next 10-years. Even if that return was generously rounded up to 5% – for illustrative and simplicity purposes – 5% is not 7%. So, how can investors potentially move from a 5% to a 7% expected return? The 3 rules of the low-return imperative Aside from attempting to win the lottery, investors generally can attempt to increase the value of their nest egg through a combination of saving more, spending less or finding higher return opportunities. Of course, these choices are not always easy: Saving more effectively means lowering the current standard of living; spending less means either having a shorter retirement or a lower standard of living in retirement; pursuing a higher return can mean contemplating investment strategies that may be beyond the investor’s risk comfort zone. Many investors are currently focusing on reducing fees as a way to potentially increase the actual performance received. However, prioritizing fees can cause investors to rotate out of actively managed investments into passive ones – thereby decreasing the likelihood of achieving a greater than the estimated 5% index-based return. A passive portfolio may make that 5% expected market return more “certain” than an active portfolio – but 5% is not 7%. In our view at Russell Investments, this challenging market environment creates a very simple low-return imperative for investors: So how might an investor earn incremental return to help close the gap between the expected 5% passive return and 7% required return? A skilled investor could potentially generate net of fee performance above the passive index by:

• selecting above average active managers
• maintaining targeted exposures to investment factors (for instance value, momentum, quality, low volatility)
• dynamically adjusting the portfolio’s asset allocation
• judiciously applying leverage and illiquidity where appropriate.

Of course, these strategies add uncertainty and risks, but also offer the potential to get investors closer to their required return of 7%. 5% is not 7% – an investor example Meet Bob. Bob is 45 years old, makes $100,000 a year and plans to retire in 20 years. His current nest egg is worth $155,000. Bob and his financial advisor have determined that Bob will need $40,000 per year in retirement – which, by their calculations, would require a $1,000,000 nest egg at retirement. If Bob saves 10% of his income for the next twenty years, and earns a 7% return on his portfolio, he will reach his $1,000,000 goal in twenty years. However, if his portfolio earns a 5% return, he will have only $741,000, which, at a 4% withdrawal rate, would generate an annual retirement income of only $29,640. In order to get the same expected retirement income, he would have to save $18,000 a year rather than $10,000.