Is It Still Worth Investing in Stocks?

Forecasts point to lower future investment returns and, more specifically, to a lower equity premium return for stocks over bonds. If indeed we will experience a lower equity premium, how much lower of a premium will make stock investing unattractive relative to bonds? I’ll develop an example based on a retirement scenario to help us think through this issue.

The example

I’ll compare retirement outcomes based on the historical average equity premium versus a lower equity premium. The issue of future investment returns and safe retirement withdrawals was recently addressed in this Advisor Perspectives article by Bill Bengen, and his article responded to this Morningstar paper on safe withdrawal rates that has been receiving considerable publicity.

Here are the specifics for my example. For investments, I establish a baseline by assuming a 0% real arithmetic average return for bonds. Current yields will have a strong anchoring effect on bond returns for retirements in the near term and those yields are currently negative, so I am assuming some offsetting yield improvement over time. For stocks, I set up two scenarios: a 7% equity premium for the historical scenario (based on Ibbotson for large company stocks) and 5% for my alternative scenario. For both scenarios I assumed standard deviations of 20% for stocks and 7% for bonds based on history. I used a 60/40 stock/bond portfolio with rebalancing to maintain that allocation. Other assumptions included $1 million of initial savings, $30,000 of annual Social Security income, and a fixed 30-year retirement period. I set up annual retirement withdrawals that are based on RMDs and will therefore vary with investment performance. More specifically, I used RMD factors developed from the extended IRS table for couples beginning at age 65, and multiplied those factors by 1.25. The 1.25 generates reasonably level real expected withdrawals over the retirement period. These assumptions feed into a Monte Carlo model that generates 5,000 30-year retirement scenarios.