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Despite the market crash of 1987, the aftermath of the dot-com bubble in 2000-2002 and the Subprime Mortgage Meltdown of 2008, investors have enjoyed an exceptional bull market during the period from 1985 to present. But a report issued by McKinsey & Co., Diminishing Returns: Why Investors May Need to Lower Their Expectations, indicates that the next generation of investors cannot expect to enjoy the same tailwinds in the markets that previously existed. Financial advisors, therefore, need to be prepared to lower their clients’ expectations concerning investment returns accordingly.

A Confluence of Factors

The McKinsey report begins by addressing the economic factors that have combined to contribute to the enduring bull market that has bounced back from every dip it’s had in the past 30 years. Some of these factors include a dramatic decline in both the rate of inflation and interest rates from the highs in the 1970s, strong growth of GDP by many nations worldwide, a large and able-bodied workforce, massive growth in China and improvements in productivity that led to higher corporate gains. Corporate profits have been fueled by dwindling tax rates, revenue from new markets and improvements in automation and global chains of supply that have kept costs in check. The convergence of all of these factors led to average returns in the markets that substantially exceeded the average returns of the previous 70 years, from 1914 to 1985. (For more, see: McKinsey: Golden Age for Investors About to End.)

Trend Reversal

The study then reflects upon the fact that many of these trends have petered out and are starting to head in the other direction. Interest rates and inflation can go nowhere but up at this point, and their eventual rise is certain. The forecast for our GDP growth is also fairly weak, as our labor force is aging and has ceased to expand, and gains from new methods of production have leveled off. Another major factor that could slow market growth is the fact that the big conglomerates that often grew the most during the past few decades are now facing stiff new competition from newer firms in the emerging markets that are willing to operate on slimmer margins and accept a lower level of profit.

For example, just over 20% of the Global Fortune 500 now consists of Chinese companies. Small and mid-sized companies are also now able to market themselves and provide a level of service that is similar to large corporations via digital platforms and other new technologies that are provided by such companies as eBay and Amazon.com. The study also reveals that changes in price-to-earnings ratios and a 60% increase in corporate profits helped to lift the returns in the market over the past 30 years to more than 3% above the average 50-year returns. (For related reading, see: What Your Clients Must Know About ETFs.)

When these factors are all combined, the study indicates that investment returns for equities may lag the returns posted in the previous three decades by anywhere from 1.5-4%, and bond performance may lag previous returns by as much as 3-5%. (For related reading, see: What the Future Holds for ETFs.)

McKinsey isn't alone in those muted return assumptions. Elroy Dimson, a professor at the Cambridge and London Business Schools, co-authored an investment return study that covered 23 countries and utilized over 100 years of data that contends that the future long-term real return on a balanced portfolio of bonds and equities will be 2-2.5%. Fund manager AQR came up with a similar figure — 2.4% — by assuming annual dividend and profit growth of 1.5% for a 60/40 equity/bond portfolio. Assuming an inflation rate of 2%, as AQR does, that 2.4% real return equates to a nominal one of 4-4.5%.

By comparison, the National Association of State Retirement Administrators (NASRA) says that the average U.S. state or municipal pension fund assumes a nominal annual return (irrespective of inflation) of 7.69% in the future. And why shouldn't they? Over the last five years, the median pension fund has earned 9.5% (annualized). And over the last quarter century, those same funds have returned 8.5%. (For related, reading, see: Smart Beta ETFs: Latest Trends and a Look Ahead.)

Working Longer, Saving More

These depressing conclusions ultimately mean that a 30-year-old working today who saves the same amount for retirement as one from a generation ago will have to either work for another seven years or else begin saving almost twice as much. Many retirees may also have to plan on spending less in retirement and foregoing amenities that they were counting on. And while many experts feel that the millennial generation is up to the challenge, they will have a tougher row to hoe than their parents and grandparents. (For related reading, see: Crowdfunding: What Advisors and Clients Must Know.)

Of course, individuals are not the only ones who will feel this bite. Pension fund managers who are basing payouts on 6% to 8% returns in their portfolios will also be forced to make some unpleasant choices. They can increase the contribution levels (which will, of course, come with its own set of repercussions), reduce payouts, raise the retirement age or invest in offerings that carry a higher level of risk to achieve an acceptable rate of return. Portfolio managers may likewise be forced to turn to alternative investments such as private equity or derivatives as a means of boosting returns. Another possibility would be for them to eschew asset-based sectors and look to idea-driven sectors, such as pharmaceuticals, media companies, and the technology sector. There is a substantial gap between the leading companies in these sectors and their competition, which could allow managers who pick stocks to provide a greater level of value for investors by sticking to the winners. (For related reading, see: Smart Beta: Set Up for a Fall?)

Key Omissions

It should be noted that the McKinsey study has omitted three key areas of the economy in its report in an effort to maintain simplicity. The first area is real estate, which has historically outpaced inflation along with the stock market. The second area is emerging markets, which comes with starting valuations that are lower than developed markets and also have produced higher returns. The third area is small companies, which also have posted strong historical gains despite their volatility. The report admits that the inclusion of these segments into its report has the potential to move its market projections upwards. (For related reading, see: Alternatives for Low-Yielding Bonds.)

The Bottom Line

If the McKinsey report proves to be true, then saving for retirement may be harder than ever for working Americans today. The confluence of events that combined to drive the markets over the past 30 years appears to be dissipating, and in its place, there seems to be an economic environment that is less conducive to market growth. But the factors that are ignored in the report may push returns above their stated expectations, and new technologies that could allow corporations to maintain their current profit levels while minimizing costs could also boost their projections. (For related reading, see: Income vs. Total Return: Withdrawals Reconsidered.)

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