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60/40? Do you have the right mix of shares versus bonds?

Bonds have been a beautiful investment over the past couple of decades, compounding returns at a decent clip while faithfully filling their traditional role as buffers in down markets. But now that interest rates are close to all-time lows, their future return prospects are much lower.

In this article, I’ll explain why investors saving for retirement should consider shifting their asset allocations to lean more heavily on stocks. I’ll also run through some of the pros and cons of doing that, especially when it comes to downside risk.

Assumptions needed for planning purposes

We generally avoid making predictions about long-term market returns. But for planning purposes, investors need to use some type of return assumptions instead of just throwing up their hands in the face of unpredictable future returns.

Looking at long-term historical norms is a place to start. Over the past 92 years since 1928, Treasury bonds in the US have averaged annual returns of 5.15%, while medium-quality corporate bonds have returned 7.22%. If you subtract inflation, real returns are 2.17% for Treasuries and 4.22% for corporates.

But it’s highly unlikely that bond returns will reach the same level over the next 10 years. The yield on the 10-year Treasury has steadily declined over most of the past 20 years, and the Fed’s recent interest-rate cuts have pushed yields down even further, as shown in the chart below.

Exhibit 1: 10-Year U.S. Treasury Yield Over Time

Source: U.S. Treasury/ Data at 31 May 2020

Yield makes up much of the return bond investors earn, so rock-bottom yields suggest future returns are likely to be far lower than in the past, and may not even keep up with inflation. Lower future returns have profound implications for retirement planning. Investors who stick with the same asset-allocation guidelines that worked in the past will likely fall short of their goals.

How should portfolios change?

Take a hypothetical 50-year-old investor who starts with a $300,000 balance invested in a portfolio combining 60% stocks and 40% bonds. If she’s able to sock away $500 per month over a 15-year period, the outcome looks pretty good if you assume the same rates of return we’ve seen over the past 15 years. But if we ratchet down the return assumption for bonds to 1.5% annually, the investor ends up with about $150,000 less, which might translate into a year or two of retirement spending.

Even those projections might be too aggressive because they assume equity returns stay at the same level over the next 15 years. With a more conservative assumption of 7% nominal returns for stocks, the ending balance would total about $264,000 less.

Exhibit 2: Potential Savings Gap

Source: Author's calculations. Return assumptions are based on weighted returns for a 60/40 portfolio. Assumes a starting balance of $300,000 plus $500 monthly investments over a 15-year horizon. Date as at 31 May 2020.

Stocks to the rescue

Of course, the safest way to improve a long-term portfolio’s prospects is to boost contributions (or reduce withdrawals, if you’re retired). But a higher equity allocation could help fill some of the gap.

If we shift to an 80/20 mix and stick with the more conservative return assumptions, the ending balance gets a bit closer to the original level, reaching $870,000. Even shifting to a 90/10 mix (which would be more aggressive than the typical target-date fund with a 15-year time horizon) doesn’t quite get the ending balance back up to the original level. It would reach about $939,000 instead of more than $1 million.

How much is too much?

Of course, higher equity allocations come at a cost. As shown in the table below, there’s a direct relationship between equity exposure and risk. These numbers are for the US market but the same principles would apply in Australia.

The standard deviation (a measure of risk) for a portfolio combining 80% stocks and 20% bonds is about 34% higher than the traditional 60/40 asset mix.

Exhibit 3: Risk/Return Trade-offs for Different Asset Mixes

Source: Morningstar Direct. Data through 5/31/20.

Looking at performance during previous market downturns is another way to gut-check your risk tolerance before making any shifts to your asset allocation. For example, in the COVID-19 correction from 19 February to 23 March 2020, a portfolio with an 80% equity weighting would have lost about 27%, compared with a 21% loss for a portfolio with a 60% equity stake (using the US data above).

Exhibit 4: Performance in Previous Market Downturns

Source: Morningstar Direct. Data as of 31 May 2020.

Conclusion on the right allocation

Ultimately, the 'right' asset allocation is incredibly personal. Risk tolerance is a key input, but so is risk capacity, the amount of risk you can take given your proximity to needing to spend from your savings. If you’re within a few years of retirement, having an allocation to safer assets like cash and bonds won’t just lower your portfolio’s volatility; it will help ensure that you don’t have to invade your equity assets when they’re down.

At the same time, low bond yields don't bode well for future returns. That suggests overweighting bonds is apt to reduce returns, and may result in a shortfall for investors who allocate too much to them in the name of safety.

Investors will likely need to pursue multiple strategies to help address the potential savings gap. Significantly increasing pre-retirement savings and reducing planned spending can improve your odds of success.

But if you’re willing to take on additional risk - and confident that you won’t be tempted to sell during market drawdowns - increasing your equity exposure can help fill part of the shortfall.


Amy C. Arnott, CFA, is Director of Securities Analysis for Morningstar. This article is general information and does not consider the circumstances of any investor. 

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jeff oughton
June 28, 2020

Here's a lifetime retirement solution - unlock private savings at an attractive price!

A lifetime loan at 4.5% from the Australian government - it's called the exisiting pension loan scheme - either taken as income or saved and shifted into equities if not consumed - to boost your retirement income and top up your equities returning 6-7% pa over the medium term.

And over the 20-25 year holding period for a 65 year old, there is significantly less expected volatility on the total net wealth and retirement income will have been substantially boosted.

The retiree just has to be willing to partly rundown the private savings in their biggest illiquid asset - their home!

PS - And the govt should drop the pls rate to the covered bond rate + say 1.5% = 3% .

A good deal for the govt objective for jobs and growth and a good deal for the asset rich but income poor retiree with a home and insufficient income!

David M
June 27, 2020

Clearly the author hasn’t worked directly with retiree clients through a volatile market. Here we are, at a point in time where we question the recent market recovery and it seems no one quite knows what will happen, and the suggested solution is to increase portfolio risk to 80%? In order to get yield? The reality is that the yield isn’t as it should be in cash bonds or shares. Diversification and caution will allow you ability to withstand and take advantage of whatever the future holds. Making sure clients understand that low returns are likely and discussing the choices available is my path.

jeff oughton
June 26, 2020

Here's a lifetime retirement solution - a lifetime loan at 4.5% from the government - it's called the exisiting pension loan scheme - either taken as income or saved and shifted into equities - to boost your retirement income and top up your equities returning 6-7%.

And over the 20-30 year holding period, historically there will be little be significantly less volatility, your retirement income will have been substantially boosted .

The retiree just has to be willing to partly rundown the private savings in their biggest illiquid asset - their home!

PS - And the govt should drop the pls rate to the covered bond rate + say 1.5% = 3% .

A good deal for the govt objective for jobs and growth and a good deal for the asset rich but income poor retiree with a home and insufficient income!

jeff oughton
June 25, 2020

How about a lifetime loan at 4.5% from the government - the pension loan scheme - either taken as income or saved and shifted into equities - to boost your retirement income and top up your equities returning 6-7%.

And over the 20-30 year holding period, historically there has been little if any volatility.

The retiree just has to be willing to rundown the private savings in their biggest illiquid asset - their home!

PS - And the govt should drop the pls rate to the covered bond rate + say 1.5% = 3% .

A good deal for the govt objective for jobs and growth and a good deal for the asset rich but income poor retiree with a home and insufficient income!

June 25, 2020

I am currently considering this exact option. One of the plusses is that with more in equities the income is higher and reduces the need to sell down principal to fund retirement. As long as you can ride out rough patches and don't need a new car in the 1-2 years. The problem is once you were compensated for not being in riskier shares by a decent yield on bonds/term deposits. You didn't get much capital gain but you had income. Once bonds don't compensate, and in fact the 'magic' of compounding goes negative (locking in the opportunity cost of less income of say 4% a year, in 5 years you have a solid 20% cumulative loss) makes the 'safety' of bonds appear over-rated??

Ian N
June 24, 2020

There is certainly no text book solution to the current environment. When I commenced my SMSF I followed the Morningstar bucket approach where you held enough cash for living expenses for 1-2 years with fixed interest holdings maturing in 2-3 years providing a buffer for any downturn in equities. Today I have enough cash for 1-2 years reduced my holdings in fixed interest and moved more money up the risk curve to equities. The problem is the RBA seems to be following me up the risk curve buying treasuries, corporate bonds and potentially equities. In Covid-19 speak we are not only flattening the curve but with the RBA in the market they are certainly flattening the returns and alternatives available to a Retail Investor.

Lisa D
June 24, 2020

I like Steve D’s approach: in the medium term, bonds which were acquired in the last two to three years are still providing a good yield and a safe haven, although short term reductions in bond value mean selling now will result in a loss. Likewise, structuring a bond portfolio to include short, medium and long term maturity dates enables both the ability to hold bonds to maturity and therefore protect capital investment and also to diversify investment into equities or term deposits as each bond matures. Equities should always of course be monitored and reviewed regularly; including the option that exchange traded bonds, global funds and capital notes offer; through adding variety and spread in your asset mix. This is what I do with my own SMSF, and it is not weighted to equities as I am already in retirement. Equities however continue to provide at least 25-40% of annual returns from dividends and distributions.

June 24, 2020

This is, in a nutshell, the challenge facing everybody today who is trying to manage multi-asset portfolios. Bonds have lost their dual role of capital preservation and income generation and now are almost only suitable for capital preservation (and sometimes not even then, a la Virgin Airlines).

The problem is that a 80/20 or even 90/10 portfolio is a totally different beast from your typical 60/40. Taken to the extreme you end up with a portfolio of 100% equities, which is usually far too volatile for the majority of investors (particularly where investors may need to fund large one-off events such as paying off the mortgage or funding a place in aged care).

The approach we have adopted at our firm is to try and leave the 60/40 allocation (or whatever it is) in place as much as possible, but adjust a portion of the equities component in order to increase the potential returns. So you might take 10% of the portfolio's equities allocation and sell CBA, TLS, WOW and COL (for example) and reinvest those funds in XRO, RMD, CSL and NXT (for example). In this approach you still benefit from the capital security of the investment in bonds, but (hopefully) juice your overall return somewhat. This approach recognises that not all equities are equal in regard to risk and potential return and tries to use that to balance out the loss of income from bonds.

Another approach is to increase the potential returns in your bonds through investing in high yield and emerging market bonds, but to my mind the risks far outweigh the potential returns and this should be avoided. Keep the 'safe' part of your portfolio safe and increase the risks where it's more appropriate (in the equities component).


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