The Seven Great Challenges to Retirement Plans

Larry SwedroeInvestors planning for retirement are facing seven significant challenges: historically high equity valuations; historically low bond yields; increasing longevity and the potential need for expensive long-term care; the failure of government to fully fund the Social Security and Medicare programs; the likelihood of slower economic growth due to the rising debt-to-GDP ratio; and the end (and even likely reversal) of favorable tailwinds for corporate profits (falling interest rates, profits growing faster than GDP, and falling tax rates).

  1. Historically high equity valuations

From 1926 through June 2023, the S&P 500 provided an annualized (compound) rate of return of 10.2%. With the Consumer Price Index having increased at a rate of 3.0%, the S&P 500 provided a real return of 7.2%. Unfortunately, many investors make the naive mistake of extrapolating historical returns when estimating future returns. It’s an unfortunate error because some of the returns to stocks in this period were the result of a declining equity risk premium, resulting in higher valuations. Those higher valuations forecast lower future returns.

The best metric we have for estimating future returns is the Shiller CAPE (cyclically adjusted price-to-earnings ratio) 10. As of July 22, 2023, the Shiller CAPE 10 stood at 31.6. The best predictor we have of the real future returns to equities is the inverse of that ratio (the earnings yield, or E/P), producing a forecasted real return of just 3.2% – less than half of the 7.2% historical return. To get an estimate of nominal expected returns, we can add the difference between the yield on the 10-year nominal Treasury bond (which stood at about 3.8% on July 22, 2023) and 10-year TIPS (about 1.5%), about 2.3%. That gives us an expected nominal return to stocks of just 5.5% – about half the historical level.

The forecasts for international returns are better, though also below historical returns. The Shiller CAPE 10 earnings yield for non-U.S. developed markets and emerging markets at the end of June 2023 were 5.6% and 7.3%, respectively. If forecasting nominal returns, 2.3% should be added for expected inflation. Thus, if you have an allocation to international markets, your forecast for returns should be somewhat higher than for a U.S.-only portfolio.

Unfortunately, the bond side of the story is not any better.