Those who pay attention to the news are regularly bombarded by a barrage of economic data – from unemployment figures to the inflation rate – as there is no shortage of data points available to assess the state of the economy. But for financial advisors, a key question is how this information may influence the plans they create for clients, and how it can impact the retirement income recommendations they make. Three economic factors, in particular, are relevant to retirement planning that can be helpful for advisors to consider when discussing retirement goals and recommendations with clients. These include expectations around market return based on long-term historical price and earnings data, ‘Nest Egg’ measures that assess the impact of historical sequence of returns on savings trends and forecast future withdrawal rates, and long-term inflation trends.
The Cyclically Adjusted Price/Earnings (CAPE) ratio is used to assess stock market valuation averaged across a period of time (typically 10 years or longer). While a high CAPE value suggests that stocks valuations are less favorable (and corresponds to lower historical sustainable portfolio withdrawal rates), today’s very high CAPE values indicate that advisors could be cautious about clients’ portfolio withdrawals, particularly for long retirement periods (given that CAPE is not an effective short-term timing tool) and especially for portfolio tilted toward stocks (as CAPE is especially relevant to stock-heavy portfolios).
For portfolios not tilted toward stocks, other indicators such as prior sequence of returns can be more helpful. For example, historical data suggests that periods supporting lower withdrawal rates would have given retirees larger account balances from which to withdraw, thereby cushioning the blow of poor sequence of returns to some extent in retirement. This ‘Nest Egg’ approach suggests that those with strong investment returns during one’s working years might require more cautious portfolio withdrawals in retirement (as reduced returns are anticipated in the future, and particularly for longer time horizons). While the current Nest Egg measure may not seem very low from a historical viewpoint, it is currently in the third quartile of historical levels, which means that it is significantly lower than other periods (e.g., in January 2000 before the tech bubble burst).
While current inflation data is likely to be on clients’ minds, longer-term inflation trends tend to be better predictors for sustainable retirement spending, particularly for bond-heavy portfolios. And because inflation tends to be mean-reverting, long periods of low inflation are usually followed by higher inflation (which depresses real sustainable withdrawal rates). Given that current long-term inflation measures are still well below historical averages (despite the inflation seen during the past year), advisors and their clients could prepare for higher inflation (and potentially reduced real returns, particularly for bond-heavy portfolios) when planning for long-term sustainable portfolio withdrawals.
Ultimately, the key point is that while no single economic indicator can reliably determine future market returns, considering multiple factors together can give advisors a better idea of how sustainable portfolio withdrawals might change going forward. Advisors can also use economic data to illustrate to clients how the economic situation today (in terms of CAPE, Nest Egg measures, inflation, for example) compares to the past, and to demonstrate what sustainable spending looked like in past periods with economic environments similar to that of today. While economic factors consider only a limited aspect of a retiree’s financial plan, they can add valuable and insightful context both to the conversation around retirement planning and to plan analysis itself!