By Joseph Caplan
Oct. 8, 2024
Planning for retirement has always been a multiyear process that requires thoughtful and consistent attention and actions. Yet retirement planning for younger investors has become even more challenging relative to the previous generation due to certain secular changes that have created new obstacles.
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What has changed? Here are some of the most significant shifts:
How we save for retirement. Decades ago, one of the key components to successfully planning for one’s retirement was the ubiquity of company pension plans, which were structured as defined benefit plans and offered by many large public and private institutions.
In recent years, due to the rising cost and risk of managing and funding pension plans, companies have shifted to 401(k) plans, putting much more of the financial burden on the employee. While 401(k)s are an efficient retirement savings vehicle, they do not offer the same guarantees and predictability as a pension plan.
Young people’s ability to save. In recent years, young investors have faced additional challenges in saving for retirement. The economy has experienced inflationary challenges, specifically in already high-price industries such as healthcare, housing, education, and automobiles. At the same time, wages have not kept up with the rising costs of living, therefore making it harder for savers to maximize workplace retirement contributions and other retirement vehicles.
Market conditions. From 1980 to 2020 were the ideal years to be invested in U.S. markets. Equity and fixed-income markets both enjoyed the benefits of broad economic growth with low inflation. While the U.S. economy experienced several significant economic downturns during this period, recoveries were swift and equity markets were able to quickly recoup losses during those periods.
A confluence of unique factors helped boost U.S. equity returns well in excess of historical averages. Growth in the technology and communication sectors drove significantly higher economic productivity, which translated into strong earnings growth. We experienced an unusually long period of low inflation, despite the stimulative policies of both fiscal and monetary governing bodies. Reasons for low inflation included mass globalization and vast technological advances. At the same time, investing became much cheaper, accessible, and liquid—benefiting all investors.
Now, with broad U.S. market indexes hitting record highs in 2024, there are reasons to believe that future returns won’t be as strong, and volatility could be higher. For one, markets have become highly concentrated in a few sectors and individual companies, which creates high sensitivity to adverse conditions. Second, federal deficits and public debt levels continue to grow to record levels. These levels are likely unsustainable and therefore may result in some pain, whether that entails higher taxes, weaker growth, higher inflation, or some combination. Reducing our debt and deficit levels wouldn’t only affect consumers but could negatively affect stocks and bonds as well.
Lastly, there have been numerous headwinds facing the broad economic and geopolitical landscape that were largely muted for the previous generation. This includes inflation, global wars threatening key functions of the macroeconomy, and initiatives in certain developed countries to withdraw from global trade, including onshoring efforts and threats of new tariffs.
On the fixed income side, while many investors do not consider bonds a means for significant capital growth, those who invested in fixed income in the early 1980s—and well beyond—likely experienced once-in-a-lifetime growth in real returns. Interest rates had risen as high as 20% in the U.S. in 1980 and moved to unprecedented lows of 0% in 2008 and 2020. An interest rate decline of this magnitude is unlikely to emerge anytime soon, thus making it significantly more challenging to generate the same fixed income returns as the prior generation.
Other planning considerations. Other factors making it challenging for young investors to plan for retirement today include longer life spans, questions about the soundness of Social Security and Medicare, and a continued rise in healthcare costs.
So, is all hope lost? Not at all.
The key factor that young investors have on their side is time. With a long time-horizon and proper planning, young investors can position themselves today to retire comfortably in the future. However, they are likely to face a diminished opportunity set than the previous generation to achieve retirement success.
A different playbook may be needed. Here are key elements to include:
Save more. Given the difficulties in saving for retirement today, young investors should take a few points into consideration. One, maxing out one’s 401(k) or 403(b) is the easiest solution to save for retirement. This is especially advantageous if there is a significant employer match.
Creating a disciplined process for saving can be very beneficial. Those with positive net cash flows at the end of a month (or year) have two options: spend or save. For some, it is compelling to spend excess cash flows given the temptation for instant gratification. But those who create a systematic process for retirement saving (i.e. a fixed amount each month), will have a much higher likelihood of retirement success, especially given the outsize benefits of compound interest for those who invest early.
Be smart about investing. Young people who only started investing during the previous cycle or two, may be shortsighted in recognizing the importance of proper risk management in achieving long-term portfolio objectives.
Prudent investing for retirement requires proper diversification while avoiding behavioral pitfalls such as “herd mentality.” Diversifying one’s portfolio isn’t easy, however, because of the concentration in market composition.
Believing that index investing alone adequately diversifies one’s portfolio could prove misguided. Market concentration and outperformance of a few companies has resulted in an excess market multiple relative to its long-term mean, which has resulted in elevated valuations.
Historically, when market multiples have traded well in excess of its historical mean, it resulted in lower future returns for an extended period. So rather than investing in a single index fund, investors should, at minimum, consider diversification as it relates to sectors, geographies, and individual names.
Additionally, to achieve sufficient growth that reflects one’s desired financial goals, a portfolio likely requires more than broad diversification. To position for growth while cushioning the portfolio from adverse outcomes, one should also keep “quality” and “value” factors at the forefront of their investment process.
For those with balanced portfolios of stocks and bonds, one may not be best served by following a simple formula to determine the appropriate asset allocation (i.e. 60/40). Many studies suggest that around 90% of a portfolio’s return is attributed to the mix of asset classes.
Given the historic success of both stocks and bonds in previous decades, the allocation choice between the two asset classes may have only impacted a portfolio’s risk/return profile marginally. In future years, however, the consequences of asset allocation mistakes will likely lead to unpleasant outcomes. Deciding on one’s asset allocation should be a thoughtful and ongoing process that includes measuring one’s objectives, risk tolerance, time horizon, asset/liability position, and tax position, just to name some considerations.
Successful planning is possible with proper focus. While younger investors have to deal with a different retirement playbook than their parents, financial success will require the same key steps: work hard, be disciplined about saving, and remain patient.
Ultimately, the biggest challenge for young investors today could be overcoming psychological distractions and data overload which often undermine the time-tested investing principles necessary to achieve long-term success.
A good financial and investment plan will take years or decades to prove successful. Therefore, it is important to lay the foundation of future financial success through planning now. Disciplined execution of the long-term plan will be the most essential element to achieving retirement success
This Barron's article was legally licensed by AdvisorStream.
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