Retirement planning: What portfolio returns should you expect?

Dubai: We are heading towards “New Year’s Resolution” territory again. One of the areas many people promise to focus on is their retirement plan.

While the theory behind how best to do this is relatively simple – pay off expensive debt, spend less, save more and invest – the practice is a lot more complicated. How much do I need to save? What should I invest in? And, what returns can I expect on my investments? These are all complicated questions.

The first two are very personal decisions, depending on the type of lifestyle you want during retirement and what is your ability to withstand market drawdowns. Without making assumptions on the third question, though, the first two are impossible to answer, so let’s start here.

When looking at expected returns, it is important to acknowledge that: 1) nobody has a crystal ball; and 2) the shorter the time horizon, the greater the level of uncertainty.

For bonds, if you hold a bond to maturity, assuming no default, you can calculate the total return you will get from your investment. However, in the shorter term, returns can vary significantly. The best example of this was 2022 where inflation concerns led to sharply higher interest rates and bond yields and, by extension, lower bond prices.

When trying to predict long term returns, a reasonable rule of thumb would be to look at the yield on offer on the bond, then subtract a percentage to price in the likelihood of defaults. As one would expect, the risk of defaults depends on the creditworthiness of the borrower. So, for high yield, or sub-investment grade, bonds you might want to subtract between 1.5-2.5% from the yield on offer to get the long-term expected return.

When it comes to equities, again, the short-term outlook is highly debatable. There are currently 11 analysts who share with Bloomberg their target for the US S&P 500 index by the end of 2026; the range of forecasts is from 5750 (17% below where we are today) to 7950 (up 15%). This is hardly helpful.

Longer term forecasts have a much narrower distribution. The range of average annual 10-year expected equity return forecasts is 3.6% to 7.8% (using a sample of 10 research houses). Of course, the differences are very meaningful after you take compounding into account. For instance, 3.6% return compounded over 10 years would deliver 42% returns after 10 years, while 7.8% would return 112%.

One of the trends in recent years has been for the gap between equity and bond expected returns to narrow. Initially, this was driven by the sharp rise in bond yields in 2022, boosting forward-looking returns for bonds. More recently, it has been driven by the rise in equity market valuations, especially in the US, which typically reduces long-term returns. Our 5-year average annual return assumption for global equities is 7%, while that for global bonds is 4.7%.

Clearly, this suggests a continuation of the outperformance of equities over longer time horizons. However, the narrowing of the expected return gap between equities and bonds naturally leads to the question of whether increasing the allocation to bonds makes sense. Yes, equities still offer higher potential returns, but this comes at the cost of higher portfolio volatility.

The caveat to this line of reasoning is the outlook for inflation. At the global level, inflation is expected to remain under control. However, in my opinion, US inflation is likely to be significantly higher over the next five years than seen since the Global Financial Crisis. Stylistically, from 2009 to 2020, the US Federal Reserve struggled to push inflation up to its 2% target rate. Looking forward, in might be more challenging to keep inflation below 3%.

To a non-finance person, this might sound like splitting hairs, but I believe it should make investors think very differently. At the most obvious level, it would increase the inflation drag on nominal returns on financial assets by 1.0-1.5%.

This matters for both bonds and equities, of course. However, for most bonds there is no mechanism for investors to receive greater compensation for higher inflation levels. Bonds are nominal investment vehicles that return the original investment amount plus a fixed stream of cashflows to investors. If the price level jumps 10% over 3 years, then the inflation-adjusted face value of the bonds and interest payments declines permanently.

For equities, there is an adjustment process to compensate investors for rising price levels, especially over longer time periods. Over time, corporate profitability will reflect rising prices, and this will ultimately be reflected in rising share prices and dividends. Therefore, the more you worry about inflation from a structural, 5-10-year, perspective, the higher your equity allocation should be.

There are other ways to prepare for inflation, of course. The most obvious is gold. This is an area that is very difficult to model from an expected return perspective because it doesn’t generate any cash flows. As such, formal expected returns are generally pretty low and suggestive of a low allocation in portfolios, despite gold’s portfolio diversification benefits.

Despite this, we currently have a 7% allocation to gold in our allocations. This has naturally served us very well in recent times. While we were predicting a pullback earlier in the month, the structural drivers remain intact in our opinion and, therefore, we are retaining an overweight allocation in our portfolios for now.

Finally, there are other areas that can help improve the performance of your portfolio either by enhancing returns or reducing portfolio volatility, or in some cases both. Private assets, such as private equity (expected annual returns of over 10%) and private credit (8.5%) can clearly be accretive for potential returns. Meanwhile, various hedge fund strategies (4.0-7.0%) can deliver still healthy returns, while providing significant diversification benefits.

Of course, expected returns are only the starting point of putting together a portfolio that is right for you. You also need to consider the likely volatility of different combinations of investments. This is why it can be useful to engage the services of somebody who can help you with your journey. Yes, you will have to pay for their services in one way or another, but it should really help you on put together an investment plan that enables you to achieve your financial goals.

- The writer is Global Chief Investment Officer at Standard Chartered Bank’s Wealth Solutions unit