Long-term investors could be forgiven for thinking that they’ve endured more than their fair share of suffering, having lived through two particularly traumatic bear markets over the last 16 years. However, recent decades have actually represented a “golden age” for investors, according to the McKinsey Global Institute. And the next 20 years are likely to be much tougher, it suggests, forcing savers to pony up more funds if they wish to secure a comfortable retirement.
McKinsey's report, Diminishing Returns: Why Investors May Need to Lower their Expectations, notes that US and European equity markets have enjoyed stellar returns over the last 30 years, with both markets delivering annualised real returns of 7.9 per cent.
That’s well above historical norms. Over the last century, US stocks averaged annual real returns of 6.5 per cent, while the equivalent figure for European equities was 4.9 per cent.
Bond investors have been even luckier – a 30-year bull market has resulted in US and European government bonds generating annualised real returns of 5 per cent and 5.9 per cent respectively, approximately three to four percentage points more their 100-year average.
In other words, investors have been very fortunate over the last 30 years, but tomorrow’s investors are unlikely to be so lucky. If investor returns revert to historical norms and slip by two percentage points annually over the next 20 years, the average 30-year-old will either need to almost double their personal savings rate or work an extra seven years to have any chance of getting the type of pension enjoyed by their parents.
Grave as that sounds, it could be much worse, says McKinsey. Its best-case scenario envisages that average annualised equity returns will be approximately 1.5 percentage points lower in coming decades; in a slow-growth scenario, the shortfall may be as high as four percentage points annually.
Drivers of returns
The report says a “confluence” of financial trends drove the “exceptional” returns of the last 30 years, some of which have “run their course”. In the early 1980s, western equities were extremely cheap; concerns regarding high inflation meant stocks traded on roughly 10 times profits. By the 1990s, inflation had been well and truly “wrung out of the system”, resulting in equities trading on 15 to 20 times estimates, approximately where they stand today.
The steep decline in inflation has ended, and the same is true of interest rates. Rates began falling 30 years ago, juicing both equity and bond returns in the process. Standing at historic lows today, further steep declines are “unlikely to be repeated”.
Global GDP growth, too, was boosted corporate profits, but McKinsey suggests that an ageing world population will weigh on economic growth in coming decades.
Finally, a variety of fundamental catalysts – cost-cutting enabled by technological innovation, increased access to the growing consumer class in emerging markets, falling tax rates, lower labour costs as a result of globalisation – helped drive corporate profit margins higher over the last 30 years. In the United States, for example, profit margins rose from 5.6 per cent to 9 per cent, an increase of approximately 60 per cent.
The past three decades have been “exceptional times” for US and western European multinationals, with profits growing much faster than global GDP. However, these same multinationals now face tougher competition from emerging markets, while technology is likely to disrupt many long-established business models.
The changing competitive landscape suggests after-tax profits could fall from 9.8 per cent of global GDP to 7.9 per cent, says McKinsey, “reversing in a single decade the corporate gains of the past 30 years”.
Forecasting
Sceptical commentators will rightly note that forecasting is a difficult business, to say the least; countless studies have shown that even expert predictions are generally no better than chance.
One such sceptic, money manager and Bloomberg View commentator, Barry Ritholtz, cautions that McKinsey’s report is “filled with all manner of assumptions about growth in the US, Europe and Asia”; some no doubt will be correct, but many “are likely to be wrong”.
Ritholtz is right; no one knows for sure how the next 20 years are going to pan out, and the slow-growth scenario advanced by McKinsey may be an overly pessimistic one. Even if one eschews the forecasting game, however, it is reasonable to point out that the returns generated over the last 30 years have been much higher than those recorded over previous multi-decade horizons.
Investors may think that real annualised equity returns of 8 per cent are the norm, but the last three decades have been atypical. History indicates real annualised stock returns of about 6 per cent are more common, while a blended portfolio consisting of equities and bonds has traditionally generated annualised real returns of 4.5 per cent.
Nevertheless, pension fund managers appear blissfully unaware – most US public pension funds, almost all of which are currently underfunded, are estimating real annualised portfolio returns of about 6.5 per cent, according to McKinsey.
Individual investors, accordingly, would be wise to ensure their retirement plans are not based on excessively optimistic assumptions. As noted earlier, a 30-year-old investor banking on continued above-average returns may end up working an extra seven years to fund their pension. If annualised returns fall to 3.5 per cent, then the same investor would either have to work an additional nine years or else more than double his or her annual savings, estimates McKinsey.
Role of luck
However, it's worth remembering that those estimates are just that – estimates. Ben Carlson from the Wealth of Common Sense blog notes that the McKinsey report neglects to mention how long-term returns are dictated not just by annualised returns but by the sequence of those returns.
To borrow from an example given by Carlson, a young person who saves €5,500 annually and who increases that amount by 4 per cent annually would end up with a pension pot of approximately €743,000 if his account returned 6.5 per cent every year over a 30-year period.
However, portfolios don’t rise or fall by 6.5 per cent every year – some periods are much better or worse than others, and young investors should hope that their early years of investing coincide with the weaker periods. Carlson gives the example of another investor who saves the exact same amount of money and who nets the same average annualised return – 6.5 per cent – over 30 years, but whose returns are generated in an altogether more lumpy fashion, growing by 3.25 per cent annually over the first 20 years and by 13.5 per cent in the final 10 years.
Far from ending up with a €743,000 pension pot, his closing balance is closer to €1 million, courtesy of his funds amassing more shares at the beginning of his investing career.
The lesson from the McKinsey study is that the prudent investor should guard against lower future returns by adding to their savings plans. Even then, however, the financial health of his or her retirement will be partly determined by one neglected factor – luck.
