What’s the worst error made in retirement planning today?
“The biggest mistake is estimating U.S. stock returns for the total market: The odds of getting 10% over the next 30 years are extremely low,” argues Larry Swedroe, head of financial and economic research at Buckingham Strategic Wealth, in an interview with ThinkAdvisor. “People should be planning on more like 5% or 6% … if we’re lucky.”
He identifies “significant downside risk” in the stock market with persistent inflation as the biggest risk.
In the interview, Swedroe, a member of Buckingham’s investment policy committee, discusses the possibility of the Federal Reserve’s raising interest rates not only this month but in September and possibly November.
“You have to have higher and higher interest rates to get the same impact on the overall economy [as did raising rates formerly],” he says. Years ago, the interest-rate-sensitive sectors comprised as much as a third of GDP. Now they’re “a much smaller percentage, and the [strong] service sector is 70% to 80% — which isn’t interest-rate sensitive.”
Longer-term, he sees left-tail risk, indicating the likelihood of a sharp market crash, especially in high-tech growth stocks. (“To me,” he says, “this is starting to smell like bubbles.”)
Prior to joining Buckingham in 1996, Swedroe was vice chairman of Prudential Home Mortgage and a senior vice president at Citicorp.
He authored “The Only Guide to a Winning Investment Strategy You’ll Ever Need” (2005) and subsequently published several more books, including “Your Complete Guide to a Successful & Secure Retirement” (2019), co-written with Kevin Grogan, and “Your Essential Guide to Sustainable Investing” (2022), co-authored with Samuel C. Adams.
In the interview, citing the strategy of alternative investing, Swedroe reveals that “well over 40%” of his own portfolio is in alternatives, and he names the fund he owns that pays him an 11% yield.
ThinkAdvisor recently interviewed Swedroe, who was speaking by phone from his home office in the St. Louis, Missouri, area. Here are the highlights of our interview:
THINKADVISOR: What’s the worst error being made with retirement planning?
LARRY SWEDROE: The biggest mistake is estimating U.S. stock returns for the total market. The odds of getting 10% over the next 30 years are extremely low. People should be planning on more like 5% or 6%. That is, if we’re lucky.
Bond yields today are at about 3.5%.
If you’re talking about a 60/40 [retirement] portfolio, you can expect a return of 4.5%. Can you live on that?
You have to make sure your plan includes a good estimate of expected returns.
Do you foresee a recession occurring in the U.S. this year?
The economic outlook is a bit weaker, but I think the odds are about 50/50 that we can avoid a recession. There’s still too much good news. You’re still seeing reasonably good growth in the economy.
Why aren’t the interest rate increases hurting the economy more?
Monetary policy that used to work 40 or 50 years ago doesn’t work as effectively today because the interest-sensitive sectors of the economy — like manufacturing and housing — are a much smaller percentage of the GDP. They’ve gone from a third to roughly 10%.
So the percentage of the economy that’s reliant on interest rates is much smaller.
The service sector is still very strong; you see that in the employment numbers.
So when you raise interest rates, it doesn’t have the same impact on the economy because the service sector — about 70%-80% of the economy and including health care and restaurants — isn’t interest-rate sensitive. Therefore, if they’re not hurt, you have to have higher and higher interest rates to get the same impact on the overall economy [as you did in former years].
What’s the biggest risk to the stock market over the next 12 months?
Inflation. It’s more persistent than people think. So the Fed has to stay tighter for longer. They may have to raise rates not only this month but again in September and maybe in November, to 6%.
What other risks do you perceive?
The left-tail risk [of a sharp stock market crash based on a period of underperformance] has increased, at least in the U.S. market, specifically for stocks that have driven this big rally. [That is] the high-tech growth stocks.
To me, this is starting to smell like bubbles.
What’s your outlook for the stock market longer-term?
The odds favor lower returns. The valuations on the large-cap growth stocks that dominate the S&P 500 have been very high historically, and that predicts lower future returns.
Crashes tend to happen when you have very high valuations.
The Federal Reserve published a white paper this past May called “End of an Era: The Coming Long-Run Slowdown in Corporate Profit Growth and Stock Returns.”
It says, “The boost to profits and valuations from ever-declining interest and corporate tax rates is unlikely to continue, indicating significantly lower profit growth and stock returns in the future.” Your thoughts?
The collapse in interest rates over the past 40 years has been a big tailwind for corporate profits: Interest expense has come way down. And corporations have taken advantage of the much lower rates to extend maturities.
But rates are likely to be higher than they are now; so the interest exposure will be higher. That will act as a headwind relative to the past, in which we had a tailwind.
What else is affecting corporate earnings in a big way?
The corporate tax rate has come way down in the last 40 or 50 years, from about 25% to, effectively, about 10%.
The likelihood is that rate has to go higher, and interest expense is likely to go up. Labor is probably going to recapture more of the share of the GDP because of the tightness of the labor markets.
Why will corporate tax rates go up?
The government is on an unsustainable fiscal path. We can’t keep running deficits, and we’re going to run out of money for Social Security and Medicare in 10 years. They’ll have to get revenue from somewhere!
Corporate profits as a percentage of GDP are going to come down. It wouldn’t surprise me if it happens over the next year. But this is a longer-term trend.
So people shouldn’t expect anywhere near 10% stock returns, which has been the average for the last 100 years. That’s a likely scenario for the U.S.
How much should they expect, then?
Maybe 5% or 6%, if we’re lucky. So you have to think about what that means to your asset allocation.
The picture you’re painting isn’t very nice! When do things get better?
It could get a lot worse. If people start to recognize what I’m telling you, they could say, “I’m not willing to pay big multiples if I can’t get earnings growth.”
Then you could see the market come down pretty sharply.
The left-tail crash risk has increased. It showed up in 2000-2002, 2008 and 2022. It could show up again if we get any kind of black-swan event that could trigger a problem.
This won’t happen tomorrow or next year, but it will eventually have to happen, I think.
What should financial advisors be telling their clients now? They may be confused and worried.
Clients are always confused and worried! The biggest issue is looking just at pure valuations, you have to expect much lower returns, especially in U.S. stocks.
The outlook for international and emerging markets is significantly better because their valuations are much lower. Your portfolio should be roughly 50% international.
That gives you higher expected returns and protects you somewhat against some of the risks in U.S. markets that I’ve mentioned.
What’s your current thinking about annuities?
There’s a place for annuities, but people should buy only those that are inflation-protected. A firm called StoneRidge Wealth Management is coming out with a product that, to me, looks like the best [annuity] I’ve seen.
It’s tied to TIPS [Treasury inflation-protected securities]. That means you have an inflation hedge.
What about the concept of portfolio diversification? How can people capitalize on that to a greater degree?
Most investors aren’t diversified to include assets that have now become available that weren’t before. They have much higher expected returns than equities — and aren’t correlated with the risks of stocks and bonds.
That’s why my portfolio today is well over 40% alternatives.
The best investments are senior secured sponsored by private equity debt. With the fund I own, Cliffwater Corporate Lending Fund, I’m getting an 11% yield.
It’s floating-rate debt with an average maturity of a little over 11%. That’s a much higher return than stocks are going to get.
That’s the biggest allocation in my portfolio now.
Please explain the focus of this investment.
It buys loans originated by private [equity] direct lenders to middle-market companies.
On balance, what’s the downside?
You’re getting an 11% yield to take on that credit risk. And [regarding liquidity], you can only get out about 5% a quarter.
What market sectors do you like for the next year?
I don’t play that game because it’s too tough a game to win. The competition is too high. You should never try to guess which sectors or countries are going to outperform. That’s a fool’s game.
Do you have any closing remarks?
Everything I’ve told you is well known. It’s information you can use to try to generate outperformance. But if everybody knows about it, it does you no good unless you can interpret it [in a] smarter [way] than everybody else.
However, you’re a fool if you think you can outsmart the guys at Goldman Sachs, Morgan Stanley [and others] — the big guys that are doing the trading and setting prices.
Pictured: Larry Swedroe. Credit: Tom McKenzie