Updating your Financial Game Plan for Low Interest Rates and Equity Returns

A couple of times over the last few months, I’ve read good academic papers about the impact of historically low costs of capital. So, the impact of low interest rates. And then low equity returns.

One example? The paper from Lawrence Summers and Jason Furman about ultralow long-term interest rates and the way those rates should impact fiscal policy in the Biden administration (available here:  A Reconsideration of Fiscal Policy in the Era of Low Interest Rates.)

Another example? The recent paper from Robert Shiller, Lawrence Black and Farouk Jivraj about expected equity portfolio returns in a low-interest-rate world (available here: CAPE and the Covid-19 Pandemic Effect.)

The theme you see in these papers and a few others they reference? People need to update their thinking for the pervasive impact of ultra-low long-term interest rates.

I personally find this argument extremely compelling. And if these guys get it right? Yeah, a game changer.

But the good news here? You and I enjoy actionable insights for investing and entrepreneurship if we consider how low interest rates and low equity returns impact our financial game plans. So, let me share some of the insights I think I spot.

Good Time for Borrowing

First quick observation: Now seems like a good time to borrow long.

For example, if your family plans to buy a home? Or your business needs new machinery or equipment? Or an extra educational credential would pay off handsomely but would need to be paid for with a loan?

Sober, well-planned, thoughtful borrowing makes a lot of sense if you get an economical loan and smartly deploy the funds.

Rethinking Financial Leverage

A second thing to ponder about low long-term interest rates.

If you’re a small business owner with investment opportunities that generate high returns relative to borrowing costs, you want to consider making those investments.

You know how financial leverage works. You borrow $100,000 maybe paying 5 percent interest. So, a few thousand bucks a year.

If you can earn 25 percent, or, $25,000, on your investment? Bingo. You earn big profits.

Obviously, you need to borrow at a rate that’s well below the rate you earn on the investment.

Further, you want to match the term of your borrowing and your investment. If an investment pays off over 10 years, you want to fund that investment with a 10 year loan.

Always, business risks exist with these sorts of opportunities. As you well know.

But you want to think about this idea. And if you’re comfortable with the risk-reward trade-offs, you want to keep your eyes open for opportunities.

Note: If the Covid-19 pandemic beat up your business’s balance sheet, as it beat up many business owners’ balance sheets, consider the possibility that more low-interest-rate debt provides a way to rebuild.

We Need to Save More

A third impact to consider? Low long term interest rates and equity returns probably mean you and I need to save more to get to the number we want for our retirements.

You see why we need to do this. If you and I invest in bonds paying 1 or 2 percent interest for the next decade–or next three decades–we can’t plan that these bonds will average 5 percent return over those same years.

And then the returns on other traditional asset classes also look very low in the future, at least according to the aforementioned macroeconomists. Which makes sense. Expected low returns from equity connect to the nearly zero percent long-term interest rate bonds pay.

In a recent New York Times article discussing low interest rates, another Harvard economics professor Gregory Mankiw suggests the long-run return on a balanced portfolio has dropped from a real return of 5 percent to 3 percent, roughly in line with what’s happened to interest rates. Which also makes sense.

So, if your or my old plan assumed a balanced portfolio of stocks and bonds averaging maybe five percent after adjusting for inflation?

That assumption now may mostly reflect quaint financial nostalgia.

Once you or I recalculate an appropriate savings rate using lower expected returns? We very probably need to save more or save for longer.

For example, if you planned to save $5,000 a year to get to half a million in savings in 35 years, you may need to bump that annual savings amount up to nearly $7,500 a year.

Or if you planned to save for 35 years to hit your “number,” you may now want to think in terms of working longer. Maybe (sorry) an extra ten years?

And maybe what’s really most practical? Probably we all just need to save a chunk more and work a bit longer.

Delaying Your Exit from Entrepreneurship

A related point. Always entrepreneurs face a harsh financial reality when they sell a successful business. The return on a small business investment usually greatly exceeds the return a balanced investment portfolio generates.

To use numbers that make the math easy, suppose an entrepreneur builds a business that generates $250,000 of profits after paying the owner a fair wage. If the owner sells out for $1,000,000—that might be a good guess—she or he may net after taxes $800,000.

In the past, this owner might have been able to reinvest the $800,000 of proceeds into a stock-heavy portfolio and then hoped for a generous real rate of return. Probably in the past, she or he even received that generous rate of return.

But now? Now the owner may be reinvesting the proceeds into a balanced portfolio earning a 3 percent real rate of return. So, about $24,000?

That giant reduction in return suggests some business owners may want to delay a sale. At least until they’ve adjusted their financial game plan for lower interest rates and equity returns.

Adjusting Your Safe Withdrawal Calculations

A related thing to mention. Investors planning safe withdrawal amounts from a retirement nest egg probably want to plan on a lower withdrawal rate.

In other words, say your current plan reflects the idea that you can draw 4 percent from, say, a $500,000 portfolio. That would mean $20,000 a year to start.

In this case, you should adjust that planning formula. You might want to assume a 3 percent withdrawal rate. The math of a Monte Carlo simulation suggests 3 percent works pretty well in this low return environment.

That would mean with $500,000, you plan to draw $15,000. Because .03 times $500,000 equals $15,000. Or to draw $20,000, that you plan to need $666,666. Because $20,000 divided by .03 equals $666,666.

Note: I use numbers here that keep the math simple. But most people don’t save anywhere close to $500,000 for retirement. That amount of savings at retirement, in fact, puts you at roughly the 90th percentile.

Two other notes about adjusting safe withdrawals for low returns. First, remember that the safe withdrawal rate or amount reflects a value that works if we both live a long time and encounter a bad patch of investment returns at the start of our retirement. If we don’t both live a long time and encounter an early bad patch? Low interest rates and low equity returns may not matter. Or matter much.

Second, you and I probably won’t use a crude inflexible spending percentage in our retirement. We’re going to show flexibility. And if we do that? If we use what people call a “variable withdrawal rate?” That variable withdrawal rate should work well and let us nudge our withdrawal amounts up and down. (See this useful Bogleheads resource for more information:  Variable Percentage Withdrawal Rate.)

Re-evaluate Tax Strategies

Two final quick thoughts. First, I think you and I need to re-evaluate any tax gambits or strategies that implicitly assume historical, good returns.

One obvious example? Roth IRA and Roth 401(k) account conversions. Especially when someone uses these to “solve” a future required minimum distribution problem.

If investment returns run low through someone’s retirement, drawing 3 to 4 percent each year may on its own prevent problematically large required minimum distributions.

Rethink Inheritances and Bequests

And then this last thought: Lower investment returns may also dial down the bequests you and I leave heirs. And the inheritances we receive from parents and grandparents.

To provide for a legacy for heirs in this low-interest-rate and low-equity-return environment? One may want to be slightly more proactive. Maybe that means spending less. Or gifting more. Or  better planning for our estates.

Other Resources You May Find Useful

The draft paper from Jason Furman and Lawrence Summers referenced earlier was the centerpiece of an online web conference in early December. You can view the entire two-hour conference here: Fiscal Policy Advice for Joe Biden and Congress. And the presentation is well worth watching. Even if only to see how rational, collegial and calm experts with different viewpoints discuss a tricky set of political issues. Plus, it’s fun to see some beautiful minds at work.

If you’re not used to capital budgeting (which is the math that lets you calculate returns on business investments and real estate), you might want to peek at these blog posts: Small Business Net Present Value Analysis and Small Business Investment Returns Astronomical. You might also want to peek at how one does capital budgeting for something like buying a home, which I describe in this post: Are Houses Investments?

For more information about how expected stock market returns impact safe withdrawal rates, I like the earlier thoughtful research from Michael Kitces which looks at using cyclically adjusted price earnings ratios. (See for example Michael Kitces’ discussion of using CAPE 10 to calculate safe withdrawal amounts  and the Boglehead Siamond’s update on this idea: CAPE 10 and Safe Withdrawal Rates.  Also my discussion of Siamond’s discussion: Siamond Withdrawal Rate.)

To get an idea of what investment experts think about the prospect for long-run returns, you might find it useful to review this recent article from Morningstar’s Christine Benz: Experts Forecast Stock and Bond Returns. (I would say the views of the experts mesh with what I describe here.)

Finally, if this business about lower returns in the future blindsides you and now you’re bummed out, don’t be! Rather check out our blog post series on “retirement plan b”. You have a bunch of steps you can take to address the issue of lower returns:

Why You Need a Retirement Plan B

FireCalc Retirement Plan B Calculations

cFireSim Retirement Plan B Calculations

Monte Carlo Simulation Retirement Plan B Calculations

Tips for Building a Retirement Plan B