February 3, 2023

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Rethinking Retirement for Lower Real Rates of Return

long-term trends in long-maturity interest ratesThe recent research paper, “Long-run Trends in Long-maturity Real Rates 1311-2021,” from economists Kenneth S. Rogoff, Barbara Rossi and Paul Schmelzing shares a fascinating observation: Over the last seven centuries, long-term interest rates have trended down at a slow, steady, pace.

The research provides economists and policy makers with new perspectives and insights. But it should also cause some individual investors and small business owners to rethink their retirement plans.

So I want to summarize the research, point out a couple of connections to retirement planning, and make three suggestions.

But let’s start with a quick review of the research.

Long-run Trends in Long-term Real Interest Rates

The research from Rogoff, Rossi and Schmelzing says that over the really long haul, long-term, real interest rates trend down at a steady .00016 percent each year.

Basically, a 1.6 percent reduction every century.

Four or five decades into the future, if the trend continues, long-term interest rates reach zero. Maybe even go into negative territory. At least per the trend line.

Only two shocks even break the 700-year trend. First, the bubonic plague pandemic in the 14th century in which maybe a quarter to a half of the people in Europe died. So, to put that into context, a situation roughly one hundred to two hundred times worse than the COVID-19 pandemic.

And then the second shock? The big sovereign borrower defaults in the late 16th century when three of the world’s largest governments (France, Spain and the States General of the Netherlands) defaulted on their loans.

The economists don’t explain why the long-run trend occurs. Or why it appears so steady. They do say the data doesn’t support the obvious or conventional explanations. Neither population nor output growth explain it, for example.

But despite the unanswered questions related to this new information? I think I see at least two connections to our retirement planning.

Past Returns Poor Predicter

A first obvious connection: The past may not be a great predicter of the future.

If long-term interest rates on the safest “sovereign borrower” loans, which the paper mostly looks at, steadily grind down? Gosh, that strongly suggests that the bonds many of us include in our portfolios will pay lower and lower interest rates over the coming decades.

Further, the steadily decreasing long-term interest rates paid by sovereign borrowers suggests that stock market and equity investment returns may steadily grind down, too.

The theory says that investment returns reflect the risk-free interest rate. Textbook formulas say the return on an investment should equal the risk-free rate plus a premium for bearing risk.

Thus, the unfortunate situation investors face: Not only are returns today probably lower than in the past. Going forward? They’re probably continuing to steadily decline.

A tangential comment: The popular financial planning tools FireCalc and cFIREsim look at 150-year-ish histories of stock and bond returns. That sounds pretty good as a sample size. But that may also mean they describe an investing environment where returns were maybe one to two percent above what you or I should expect in coming decades.

Note: It looks to me, as I write this in the fall of 2022, that the ten-year US Treasury bond rate is right on the long-term trend line.

Half-Century and Century Datasets Too Short

A second less-obvious connection: The steady 1.6 percent decline in long-term rates every century shows up only because Paul Schmelzing assembled a very large dataset. The researchers point out that looking at 75 years or 150 years? Not enough to spot the trend that appears once you look at the big data.

And so this notion: Working with financial planning tools (like FireCalc or cFIREsim) that predict on the basis of a 150 years or data? Or, worse probably, working with financial tools (like PortfolioCharts or Portfolio Visualizer) that predict on the 50 years of data? That seems like a bad idea to me if we’re trying to assess safe withdrawal rates.

Don’t get me wrong. I love those financial planning tools. They provide great insights.

But the small datasets they use? Yeah, probably those datasets aren’t large enough to let us see all the extraordinary economic shocks, so called tail events or black swans, that impact a safe withdrawal rate plan.

Another tangential comment: The Portfolio Visualizer also includes a Monte Carlo simulation. And that tool does provide a way to fold tail events and black swans into our planning.

Actionable Insight #1: Workers Need to Save More

Okay, so three quick suggestions as to what actionable insights investors can maybe draw from this new information.

First an insight for people still working and saving: If you’ve implicitly or explicitly based your financial plans on past returns? Probably you’re not saving enough. Or you’re planning to retire too early. Sorry.

You therefore probably need to save more, work longer, or a little bit of both.

Two ideas to throw out at you for saving more? First idea: You want to get as much remuneration as possible for your worktime. Anything you or I can do to bump our earnings a bit—like acquire a new skill—makes a huge difference. Maybe all the difference needed in fact. We want to focus then not just on the financial capital in our investment portfolios. We want to actively manage our human capital, too. (A longer discussion of this subject here: Human Capitalists in the Twenty-first Century.)

A second idea for saving more: If we’re going to work a bit longer—and two or three years should be enough to get back to plan—we want to do something enjoyable. Or mostly enjoyable. A role with interesting challenges. Something that keeps us socially engaged. Physically active.

Actionable Insight #2: Retirees Should Stay Alert

A second insight for retirees: You should not overreact to a long-run downward trend in interest rates and stock market returns. Lower real returns in the future does not mean your retirement plan fails. Rather, I think it means the chance of failure is a little higher than the popular financial planning tools show. Which you already know.

So a little extra frugality if you’re planning on a really long retirement? Maybe spending less when the stock market goes through a rough patch? That sort of thinking, to me, makes a ton of sense. Which again you already know.

Actionable Insight #3: Small Business Owners Reconsider Timing

A final thought for small business owners: If you own and operate a small business that gives you a good income? Especially a small business that keeps you intellectually stimulated and constructively engaged with life?

I’m just going to say it. You may want to delay your exit from the business. Your small business may not only provide you with a good income. The equity in your small business may significantly juice your investment portfolio returns.

Example: You’ve got a small business that makes, say, $250,000 a year. You could maybe sell the business for $1,000,000. After taxes you’ll net maybe $800,000. And that sounds pretty good. But what will you earn on the $800,000? Five percent? So $40,000 a year?

You got to think about whether you should delay the drop from $250,000 a year to $40,000 a year.

Related Resources

Here’s a link to the “Long-run Trends in Long-maturity Real Rates 1311-2021” research paper: click here to grab a copy you can read and ponder.

We’ve talked before about having a plan “B” for your retirement. This blog post might be helpful if you’re now a little bit perplexed: Retirement Plan B: Why You Need One.

Finally, if you’re interested in learning more about Monte Carlo simulations by building your own simple simulation spreadsheet, peek at these two blog posts: Stock Market Monte Carlo Simulation and Small Business Monte Carlo Simulation.