Clients often ask why we use such low expected returns in our financial plans. We typically assume returns of 4 or 5% while long term average historical returns on both stocks and bonds are considerably higher than this. Are we just being overly conservative? Are we assuming “worst case scenario”?
Sadly, I suspect we are simply being realistic. The economy, and investment assets in general, will be facing headwinds over the next 30 years which we have not experienced in generations. One is demographics, the other is interest rates and debt.
The baby boom generation has seen a nearly continuous slide in interest rates since the early 1980s. Those lower rates (aka cheap money) have fueled almost unprecedented growth in spending power of both governments and individuals. They have also caused investment prices to skyrocket as cheap money flooded into stocks, real estate, and other investment assets seeking higher returns.
Cheap money has become like crack to the economy. The more we get, the more we need it. Our cul de sac lifestyles are built on cheap debt. Our government social programs are built on low interest rates.
But rates have fallen to rock bottom. We can’t go much lower. While we may be able to enjoy these rock bottom rates a while longer, pressures will likely be building which inevitably will push rates higher. And like any addiction withdrawal of the drug will cause pain.
If interest rates on 10 year government debt rise from current 2% to 4% (and remember 4% seemed low only a few years ago!) interest expense (the largest item in the federal budget) will double. Future government spending will be constrained. This wouldn’t happen overnight, but stupidly our government has not locked in today‘s low rates by issuing long term debt, so the impacts of even a modest rate increase will be felt rather quickly in the federal budget. This fiscal drag will be a substantial headwind for the economy.
Meanwhile, on the household side with incomes barely growing, a rise in mortgage and consumer borrowing costs would dramatically reduce the affordability of big ticket purchases such as cars and more importantly to the economy, houses. And in the world of investing, the end of cheap money means corporations won’t be borrowing money to buy back stock, one of the pillars of our current bull market in equities.
When will interest rates move higher and how fast? No one knows. And I am by no means anticipating or predicting a market collapse. I will leave that to those trying to sell books. The current low interest low inflation environment that is so friendly to stock investors could continue for quite some time. A best case scenario is a slowly strengthening economy with a modest increase in rates and low inflation over a long period of time. A worst case scenario might be a rapidly expanding economy unleashes inflationary forces which push interest rates rapidly higher. That would almost certainly cause a subsequent market crash and recession. There is room to consider the arguments of both optimists and pessimists.
Looking forward over the next decade or two however, I would be surprised if interest rates do not become a drag on both the economy and investment performance. Even in a best case scenario, rates cannot continue the downward march which has fueled investment growth over the past decades. This is why we set lower return expectations than many of our planning peers. Are we unduly pessimistic? Maybe. But there is no harm in planning for the worst and hoping for the best.