A sobering look at retirement

If you're depending on the stock market for your retirement nest egg, you need to consider the words of Rob Arnott at Research Affiliates, an investment management firm.

"I worry a lot about people reaching their golden years and discovering, 'Oh, I should've saved more,' and 'Oh, I don't qualify for Social Security any more because it's means tested'. We're headed for a retirement train wreck," he adds, "and it's going to get really ugly over the next 15 years." 

Here's why. The returns you will get from your stock funds can only come from four things: dividends, earnings growth, inflation and changes in valuation.

Using numbers from Research Affiliates, Brett Arends reports in The Wall Street Journal:

• Right now the dividend yield on U.S. stocks is about 2.2%, they note. Historically, earnings have only grown by a surprisingly low 1% a year in real, inflation-adjusted terms. Mr. Arnott tells me the average since 1900 is only about 1.2%, and in the last half century just 0.6%. Will we get more in the future? With the U.S. population ageing and heavily in debt? It's hard to imagine. Throw in a 2% inflation forecast–more on this later–and Research Affiliates forecasts a long-term return of 5.2%. 

• What about changes in valuation? Some generations are lucky. They invest in the stock market when it's depressed and shares are cheap in relation to earnings. This was the case in the 1930s and the 1970s. Then they retire and cash out when the market is booming and shares are expensive in relation to earnings–such as in the 1960s and 1990s. 

• People today are not so lucky. The stock market's latest rally has lifted shares already to pretty high levels in relation to average cyclically-adjusted earnings. This so-called "Shiller PE" (named after Yale professor Robert Shiller, who popularized the notion) has been an excellent indicator of market value. Right now it's at about 22–well above its historic average of 16. The only time the market has boomed from these levels, was in the late 1990s bubble–an atypical moment unlikely to be repeated any time soon.

What does this mean for your bottom line?

An investor with 60% of his portfolio in stocks and 40% in bonds, a standard, if conservative, allocation, can expect a weighted average return from here of only about 4.1%. Strip out 2% inflation and investors can only expect about 2.1%.

Someone who saves $10,000 a year for 30 years and invests the money at 5.5% a year will end up with $760,000. Someone who only manages to earn 2.5% on their investments: Just $420,000.

"Neither pension funds nor private investors seem to have fully absorbed the grim lessons of the past decade," Arends writes. "Returns are going to be much lower. People need to save more, much more, for their retirement. If the market rally this year has given them false hope, it will have turned out to be a curse more than a blessing."

You can read the report on which this article was based here.