Corey Hoffstein over at Newfound Research put up a great presentation on how investors should respond to lower expected returns in the future. First I’ll make the standard disclaimer that my industry has been calling for lower future returns for the better part of a decade now without much accuracy. But let’s take it a face value – what are we to do now?
Corey lays out several excellent points that I want to riff on a bit below. You should really go check out the presentation before reading further – these aren’t my original ideas.
I love that Corey calls these “compounding, marginal improvements.” That’s what I’m all about. Silver bullets don’t exist in finance or retirement planning. Much of what we talk about in finance is at the margin, and only a minority of those factors at the margin are actually in our control.
First up: fees. Mine and everyone’s favorite topic, right?! If you’re reading this you know how I feel about fees in the industry. The good news is that fee compression has been working through the financial services field, with the largest impact so far on investment product fees. A decade ago it was typical for an investor to pay 1% for common mutual funds, and closer to 1.5% for international stocks, emerging markets and other assets classes outside of core US stocks and bonds. Now an investor can get a plain-vanilla global stock portfolio in a single ETF for 0.11% or less. Right away investors are increasing expected returns there by over 3/4 of 1%. ETFs and other passive (or, if you’d prefer, less-active) products also have materially lower internal trading costs than traditional mutual funds. A fund with turnover of 50-100% could be reasonably expected to have additional costs over 0.50% annually, not reflected in fund expenses. A low-turnover passive product can easily reduce that figure by half or more.
So just with product fees, we can pretty easily assume 1% higher real captured returns than an investor thirty or more years ago when all of this safe-withdrawal rate conversation started.
The third rail among financial professionals is talking about investment advisory and financial planning fees. Advisors have been working hard selling clients on the benefit of lower fee investment products, moving to more ETF strategies, all the while ignoring that the majority of the cost burden put on investors comes from advisors themselves. For years and years advisors have been telling their clients that the 4% withdrawal rate is safe and sustainable in the face of 1% advisory fees AND 1% investment product fees (and 0.50-1% trading costs). I doubt too many advisors would admit that putting a net 6-7% expected return number into a projection might be a little too rosy if the client has a 2% fee hurdle they have to clear first, but that is what has happened for decades.
By reducing the 1% advisory fee (ideally by moving to a less conflicted, more transparent fixed or flat fee), investors can again increased their expected captured returns from their portfolios. Already by focusing on these simple changes, an investor could be increasing returns by 2-3% without making a single change to the more complex aspects of their portfolios.
The next most obvious step is the bite taken from taxes, and again we have two fairly simple strategies to control the impact. First, reduce portfolio churn. Less frequent trading in fewer attempts to time the market and/or pick individual securities not only reduces transaction costs, but can significantly reduce ongoing realized capital gains (both short and long term) for investors with taxable portfolios. Year after year, investors with high-turnover actively managed mutual funds get clobbered by capital gain distributions, whether they sold shares or not. Lipper has estimated the cost of ongoing capital gains for active investors to be around 1% a year. 1% a year given to the IRS. For an investor with a 6% long-term assumption (or for better perspective, a 3-4% real return assumption), that is a massive chunk of their earned returns to be parting with. The fix is simple: don’t trade (or let managers in your portfolio trade) unless you need to.
A more complicated strategy for reducing tax costs is asset location – where do you own different slices of your portfolio, between taxable, tax-deferred and tax-free accounts. Some of this can get wonky and really thrown off by return assumptions, but the low-hanging fruit is easy. Tax-unfriendly asset classes like taxable bonds, TIPS and REITs belong in tax-sheltered accounts whenever possible.
If we can use lower turnover strategies and smart asset location to reduce tax drag from 1% to 0.50% a year, we are really cooking. We’re up to real captured returns 2.5% or more in excess of traditional investment strategies.
Corey’s piece keeps cooking. Next: more diversification.
One thing that drives me crazy about the “lower future returns” crowd is that this argument is nearly exclusively made assuming a very poorly diversified portfolio – typically 60% large cap US stocks (represented by the S&P 500 or similar) and 40% US Treasuries. In reality these asset classes make up a minority of the investable marketplace for today’s investor. International stocks, international bonds, emerging markets, real estate, corporate bonds, small caps and many other asset classes that may have higher expected returns are often left out to paint a dark picture. Simply owning a more well diversified portfolio is going to increase expected risk-adjusted returns without much to-do. I cannot think of a single good argument for only owning a US stock/Treasury portfolio. Don’t do that.
There are more great points made in the piece, ones that every investor and their advisor should be considering, including planning-centric topics like portfolio glide paths (probably an idea that has survived much longer in academia than in real life) and fixedly increasing 4% withdrawals (something I’ve never seen happen in practice). Those two topics are deserving of their own commentary, perhaps in the near future!
If you haven’t already been thinking about these things, or your financial professional hasn’t, it’s time to take a hard look at your decision making process and expert advice. This is where the rubber meets the road and the places where a thoughtful financial advisor actually has the opportunity to add value.