Summary

• Many retirees count on the stock markets to deliver the robust growth required to beat inflation and provide an aggressive inflation adjusted spending rate.
• The stock markets have periods when they have provided 14% plus inflation adjusted annual gains.
• In periods of high growth, a retiree was typically able to purchase or hold stocks at very attractive and sensible price to earnings ratios. Today is a different story.
• From today, the equity markets may not provide the growth necessary to provide 4% inflation adjusted returns for retirees.

Those who have headed into retirement over the last 3-4 years, or who are entering retirement today, face the prospect that the equity markets such as the S&P 500 (NYSEARCA:SPY ) or total market (NYSEARCA:VTI ) simply will not deliver the growth necessary to provide a 4% (and above) spending ratio that is inflation adjusted.

In the article. Retirees, All You Need is the S&P 500 and Cash, I demonstrated that a simple SPY plus 3 years of total spending in cash portfolio would have provided 40 years of inflation adjusted spending, with an initial 4% spending ratio (of total assets). That portfolio has a high probability of success historically. In fact the S&P 500 as a sole holding will do the trick from most start dates with a 91% success rate (again with that initial 4% inflation adjusted spending ratio) of providing spending for 35 year and plus time horizons according to moneychimp.com.

That’s because historically, the equity markets have provided some very generous returns over the last several decades. As I stated in the linked article the S&P 500 has delivered, and then some. Total return calculations courtesy of moneychimp.com.

Because the stock market returns were outrageous. From January 1979 to end of 2006, the stock market provided average annual returns of 14.64% according to moneychimp.com. The inflation adjusted real returns over that period were 9.19% per year. From January of 1979 to end of 1999 the market delivered average returns of 18%, annually.

Again, there is nothing average about those returns. That said, perhaps those returns were somewhat expected as an investor had the opportunity to purchase the equities at incredibly attractive price to earnings ratios — based on the trailing PE ratios and the Shiller PE ratio models.

As I wrote in the (very lightly viewed, ha) article in Defense of the Shiller CAPE Ratio, It Works — the Shiller Index appears to have predictive capabilities. The Shiller CAPE ratio, based on the work and ideas of Benjamin Graham, smoothes out the earnings trend, taking into account 10 years of earnings history. While there is certainly the possibility of outlier periods, the CAPE ratio certainly had predictive qualities. When the PE ratios are low and well below averages and norms, the markets typically delivered very generous gains. When the Shiller PE is high we can expect lower returns. Here’s the eye opener from that article. From today’s valuation levels average 10 year returns for the S&P 500 were under 0.5%. Real annual returns over 10 year periods from the start dates of January of 1999, January of 2001, and 2002 are in the area of -3.89 to 1.54%.

A recent Seeking Alpha article on CAPE ratios that uses a modeling system that takes into account many factors suggests these nominal returns.

This leads us to believe that the 4.2% expected returns over the next ten years is a reasonable estimate.

Of course there is the potential for stocks to go higher if investors are willing to pay more for earnings. That phenomenon certainly occurred in the 199 0’s bull run as investors continually drove up PE ratios into the tech collapse. Shiller charts courtesy of multpl.com.

In my previous article that demonstrated the historical success of the S&P 500 and 3 years worth of spending in cash, the portfolio survived due to stock returns in the 198 0s and 199 0s well above historical norms and averages. The PE ratios of the time supported that likelihood.

For much of that period, the Shiller PE ratio was at or below the 15 level, the area that Benjamin Graham suggested as a sensible time to buy stocks.

Here’s the more recent Shiller PE levels.

The buying in the late 9 0s and 200 0s has been at very high valuations. And true to form, the returns from the equity markets have typically not been very generous. Retirees with start dates in the late 9 0s and through to present have been presented with a challenging scenario. Retirees who have left the work force in the last couple of years (or are about to retire) have a very serious challenge and must consider head on that the equity markets may not deliver much from here.

More on that in this article. There’s No Money To Be Made From Here, Maybe.

And not just to pick on stocks, but perhaps the bond markets and cash do not look good from here? I am not a pessimist but stock market valuations look, well let’s write unattractive to be kind, bond yields are low and leave little room for a very generous or continued bull run, and cash is delivering next to nothing. All said, the investment dollars have to flow somewhere. There will be an asset class that delivers, one would think and hope. And perhaps the stock markets will present that opportunity again at some point in the near future.

What’s a retiree to do?

While the accumulation stage and spending stage are entirely different beasts, perhaps a retiree should think like a young accumulator whose greatest weapon is investing in stocks on a regular schedule to acquire stocks when they offer sensible or attractive valuations? That would mean taking some of the recent generous but outrageous gains of the last 1-2 years off the table. Certainly my suggestion of 3 years cash and the remainder in stocks does not look prudent from here for those who might need that initial 4% spending ratio that is inflation adjusted. That investor may run into one of those periods where the modest cash and stock model fails.

Given that the markets have delivered an incredible return over the last 5 years, it may be prudent to take some of those gains and move to cash. Each investor will have to take into account their own tax situation for funds not held in registered accounts. But at this stage it may not be too conservative to hold 5 years of total spending in cash and then a nice balanced mix of stocks and bonds, to reduce the volatility that would occur in a market correction. I’d be in favor of an asset mix in the area of 50-60% stocks.

There will likely be an opportunity to buy stocks at more sensible valuations, even if in this environment bargain means the markets at a PE of 14-15. But that means having cash on hand and the ability to rebalance from bonds into stocks and eventually return that portfolio to a balanced growth (70-75% stock) allocation. Certainly some retirees will feel that is too aggressive for their risk tolerance level. They may choose to stay in the 50%-60% balanced area. Again, there’s no reason why the self-directed retiree has to remain static and flat footed. One decent market correction could set up retirees for a couple of decades to come.

Another approach would be to reduce one’s spending needs. A retiree may start out spending that 4-5% of portfolio assets, but if a correction hits, it may be prudent to reduce spending and avoid having to sell equities. One might also create an income oriented portfolio with dividend growth stocks, corporate bonds (that includes some high yield bonds) plus REITs and MLPs and live off the income of the portfolio waiting for that buying opportunity with cash that is held back.

Many write that investors need to adjust their expectations in today’s market. That advice might be even more applicable to retirees. A retiree might just have sprinted to the finish line, hitting their number due to a 43% market return over the last 22 months according to low-risk-investing.com. But just how real or secure are those returns?

Retirees might have to prepare (secure funds) to pounce on cheaper markets and adjust their spending needs.

Happy investing, be careful out there, and always know your risk tolerance level.

Disclosure: The author is long SPY, VIG, BRK.B, EFA, EWC, AAPL, ENB, TRP. Dale Roberts is an investment funds associate at Tangerine Investment Funds Limited. The Tangerine Investment Portfolios offer complete, low-fee index-based portfolios to Canadians. Dale’s commentary does not constitute investment advice. The opinions and information should only be factored into an investor’s overall opinion forming process. The views expressed are personal and do not necessarily represent those of Scotiabank. (More. ) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.