Investors Are Reassessing Stocks’ Long-Run Potential

In the late 1990s, many baby boomers confidently thought they had the stock market’s number.

That number usually ranged between 11% and 18%. It was the annualized long-term return boomers expected to earn on their stock market investments.

But now, in the wake of the most devastating bear market since the mid-1970s, a growing number of analysts predict stocks are in for an extended stretch of substandard returns.

That puts baby boomers, who are in their prime retirement savings years, in a tough spot. If they had banked on generous returns--or just historically average returns--to help their retirement savings multiply, their plans may come up short.

“Part of the return that investors have had over the past many years has been a windfall,” said Roger Ibbotson, a Yale finance professor and founder of Ibbotson Associates, a Chicago-based market research firm. “You won’t get it again.” Instead of earning roughly 11% annually on stock investments--the average return on blue-chip stocks over the last 75 years--Ibbotson is forecasting that market returns will average between 9% and 9.4% annually over the next 20 to 25 years.

In Ibbotson’s view, investors’ willingness to pay increasingly high prices for stocks relative to earnings, a major driver of the 1990s bull market, won’t continue.

That in itself will keep future returns more than a percentage point below the historical average, he said.

Other market veterans--ranging from billionaire Warren Buffett to John Bogle, founder of mutual fund giant Vanguard Group--also have warned investors to expect lower stock market returns in the decade ahead. Some say 6% or 7% might be realistic.

Even many analysts who view the plunge in share prices over the last 18 months as a temporary setback in a continuing bull market acknowledge that the piper eventually must be paid: Stock returns that far exceed the historical average tend to give way to periods of lower returns.

For example, high returns in the 1920s were followed by negative returns in the 1930s. Likewise, big gains in the 1950s were followed by below-average returns in the 1960s and 1970s.

For baby boomers set to retire later in this decade or the next, the implications of even a modest decline in average stock returns over the period are enormous.

A $100,000 nest egg today that earns an average of 11% a year would be worth nearly $900,000 in 20 years. The same portfolio would be worth $600,000 if average returns fall to 9%.

Many boomers may not have to scrap their retirement plans. However, experts advise boomers to think now about how to prevent diminished market returns from turning into diminished prospects for a comfortable retirement.

Here’s a suggested game plan:

First, Reassess

“The first thing people need to do is evaluate where they are,” said Ron DeStefano, senior vice president of Aon Consulting, an employee benefits consulting firm in Chicago. “You need to get a good sense of how much you have and how much you’re going to need.”

That’s particularly important for those who expected stock market returns even higher than the historic annual average of 11%.

A December 1999 survey by brokerage UBS PaineWebber found that investors, on average, expected to earn more than 18% on their stock portfolios in 2000. Instead, the market plunged in 2000 as the bear market began.

Unrealistically rosy projections cause workers to save too little and plan to retire too early, financial advisers say.

“A lot of baby boomers planned on rates of return that are well above the historic averages,” DeStefano said. “Those people are going to have to make some changes.”

Boomers need to reconsider what their current savings will be worth in the future, the number of years they have left to build up more savings, and how much they’ll add to their savings each year.

A key variable in all those considerations is the expected rate of return. You can’t predict the future, of course, and neither can financial pros who today believe stock market returns will be below average. But it’s at least prudent to assess how you’d fare financially if returns do indeed decline, advisers say.

Most sponsors of 401(k) plans provide tools--either printed work sheets or Internet-based calculators--that can help employees figure out how much money they’ll need to retire, and how much they’ll have to save to reach that goal.

Many of the online tools are available free. Some sites worth visiting: https://www.troweprice.com and https://www.financialengines.com.

Plan to Save More

If calculating retirement savings using reduced returns leads to projections of poverty, one solution is to save more--if the extra money can be squeezed out of current paychecks.

The government just made it easier to shelter significantly more money in tax-favored retirement accounts.

Maximum allowable contributions to all types of retirement accounts--including IRAs, 401(k)s, 403(b)s and 457 plans--ratchet up starting in 2002, sometimes by substantial amounts.

Maximum contributions to 401(k) and 403(b) plans, for example, rise to $11,000 in 2002 from $10,500 in 2001, and will reach $15,000 in 2006; the annual IRA contribution limit also rises gradually from the current $2,000 to $5,000 by 2008. Individuals who are 50 or older also can make additional “catch-up” contributions, ranging from $500 to $1,000 a year.

Saving more does two things: It creates a bigger nest egg, and it gets the saver accustomed to living on less, because there’s less disposable income to spend as the amount put into savings increases.

How much more might you have to save? Consider an investor who wants to have $500,000 in 20 years. He would have to save $578 a month if he expects an 11% annual return in that period. But if his actual returns average 9%, he would fall short by $118,000.

To have $500,000 in 20 years while earning 9% a year, this saver would have to boost his monthly nest-egg contribution by $175, to $753.

For stock investors, saving more during a bear market provides the opportunity to benefit from getting more shares at lower prices--assuming you believe there are plenty of long-term bargains out there.

“When you buy when the market is down, you are able to buy substantially more shares for each dollar,” said Dallas Salisbury, chief executive of the Employee Benefit Research Institute.

Stay Diversified

There’s nothing like a bear market to drive home the wisdom of diversification--that is, dividing your savings among a range of investments, including stocks of large and small companies, bonds, real estate and money market accounts.

As the stock market has dived over the last 18 months, government bonds have posted hefty returns. Diversified investors thus have suffered smaller total losses than investors who just owned stocks.

A portfolio composed of 10% cash, 30% bonds, 50% big-company stocks and 10% small-company stocks earned an annual average return of 9.2% over the last 75 years, according to Ibbotson data.

Although that’s less than the 10.6% average return of big-company stocks alone, it came with significantly less volatility and less risk to an investor’s principal, advisers note.

While the blue-chip S&P; 500 stock index fell 26.6% in the 12 months ended Sept. 30, the diversified portfolio described above lost 10.6%.

For anyone who plans to retire in the next decade or two, volatility and risk to principal should be major concerns that can be lessened with diversification.

Start Reducing Debts

The main factor that determines how much a worker needs to save for retirement is how much he or she plans to spend in retirement, financial experts agree.

Most retirement planning models assume that retirees will need a significant percentage of their current income--say, 60% to 80%--to live on, based on the idea that their living expenses will decrease only slightly.

But one way to reduce the amount of income needed in the future is to control debts today. Paying off home mortgages, auto loans and credit card debt will eliminate what would otherwise be major expense items in retirement.

Without debt, living expenses can be brought down to basic needs such as food, clothing, utilities, transportation and taxes.

“It’s amazing how little income you need when you don’t have any debt,” said Janet Briaud, a fee-only financial planner in Bryan, Texas.

No Early Retirement

A byproduct of the 1990s bull market was that many people starting talking about retiring early--at age 50 or 55, for example.

“What this current market situation [demonstrates] is why most people don’t retire early,” Salisbury said. “The harsh reality is that the point when most baby boomers are going to be able to retire is at 62 or 65--the age when their parents could afford to retire.”

Not only is early retirement less of an option, but Americans who based their planning on overly optimistic stock market returns may need to work past the normal retirement age to make sure they don’t outlive their savings.

Many boomers say they’re planning to do so, anyway--though they may view that prospect differently when retirement age arrives.

“Eighty percent of the baby boomers we surveyed said that they want to work into retirement,” DeStefano said.

That could have a big effect in terms of reducing the sum people need to save along the way.

For people who are physically able to keep working, there may be considerable benefits, such as employer-sponsored health insurance, DeStefano said. Also, “You don’t have to draw down your savings, and you have the opportunity to save more,” he said.

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Kathy M. Kristof can be reached at kathy.kristof@latimes.com.