Monday, January 9, 2012

The 5 Factors That Will Crush 401K Rates of Return

Conventional wisdom suggests that the rate of return of a 401K is typically around 6%. However, anyone that is calculating the size of their retirement nest egg should be extremely cautious about assuming that they will get a 6% rate of return on their investments and 401K's during the next few years. The stock market is likely to go sideways at best and most investments paying a 6% or higher interest rate include a risk premium that may make them unsuitable for a retirement account.

Here are five factors that will depress the rate of return on investments over the next few years.
  1. The Euro zone debt crisis
  2. The debt crisis that will hit the U.S., the UK and Japan sometime within the next few years
  3. The end of cheap oil
  4. Extreme weather events
  5. Retirees and the underemployed liquidating assets
Euro zone debt crisis - The so-called plans to fix the Euro zone debt crisis do not address the fact that the size of sovereign debt is growing ever larger. The solutions that are being implemented simply keep the cost of financing sovereign debt from skyrocketing to rates that are obviously unsustainable. As shown in the projections shown below, the deficits will increase the indebtedness in most Euro zone countries in 2012.  Thus, the size of Euro zone sovereign debt will be even larger by the end of 2012, and debt problem may be even worse. Further, if Europe is entering into a recession, the size of the deficits this year will be larger than shown in the OECD's optimistic projections provided below.

The austerity measures being proposed are not tough enough to balance budgets, yet will likely sting enough to stymie economic growth. The Euro zone is in a vicious cycle of misery that will spiral downward for years. The U.S. economy will be damaged by fallout from the declining European economies. 

Sovereign Debt Risk Scores By Country 
(based on OECD reports as of 1/1/12)

Unsustainable budget deficits in U.S., UK and Japan. - The disconnect between the size of a country's deficit and the interest rate required to fund its debt will undergo adjustment. As shown above, the U.S, UK and Japan are all projected run budget deficits of greater than 8% of GDP in 2012. Yet despite the huge size of the deficits, the interest rate on sovereign debt is under 2% in the U.S. and the U.K and under 1% in Japan.  The huge deficits are growing the debt to unsustainable amounts, and at some point within the next few years the interest cost on the debt will increase to levels that will suck up a huge proportion of tax receipts. Either taxes will have to be raised or spending cut, either of which will damage economies. And the inability of dysfunctional U.S Congress to pass budget acts is a wildcard that may hurt the markets.

The End of Cheap Oil - The world is running out of easy to find, easy to pump oil. The high cost of production from new sources of oil makes it unlikely that oil will ever drop down below $70 a barrel again for a sustained period of time. Demand for oil to fuel the growing car culture in China will lead to consumption outpacing production from new oil fields. When the cost per gallon of gas goes over $4 again this spring due to refineries switch over to summer blends, the hit to consumers pocketbooks will hurt the U.S. economy and the markets. The price of oil will stay elevated simply due to the high cost of production, even if there are no shocks to the market from events in the Mideast. The post Do 2012 Economic Forecasts for U.S. Foolishly Discount High Cost of Oil? includes more details on this subject.

Extreme Weather Events - The frequency and severity of extreme weather events is increasing. The U.S. will be lashed by more hurricanes and more economically damaging weather. In particular, Florida is overdue for a destructive hurricane. The occurrences of droughts and flash floods will increase. Extreme weather will lead to crop damage, higher food prices, and increased costs for property insurance. The post Will Extreme Weather Events Batter the Insurance Industry in 2012? includes additional information on this subject. 

Further, the increase in extreme weather will energize the environmental movement. The Green's will become noisier in their efforts to block economic development. Their success in delaying a decision on the Keystone XL pipeline provides an example of the Green's efforts to block economic development. They will continue to use lawsuits as a tactic to delay the development of new energy sources and oil fields. The political pressure from environmentalists that led to the shutting of seven nuclear plants in Germany (with the lost electricity being replaced by burning more fossil fuels) shows how the environmentalist agenda can damage an economy.   

The combination of extreme weather events and environmental activism may lead to the cost of diesel fuel increasing even faster than the cost of oil and gasoline. As the reliability of electricity production around the world falters due to droughts that are reducing hydro power, coal fired and nuclear power plants being shut down, and the difficulty of obtaining permits limits the building of new power generating facilities, the demand for diesel generated backup electric power has surged. 

Liquidation of Assets By Senior Citizens - The baby boomers are hitting retirement age. There will be 10,000 baby boomers in the U.S. reaching age 65 every day for the next 19 years. The new retirees will begin liquidating assets instead of acquiring them. This will put pressure on the prices of single family homes, stocks, and bonds. While the $132 billion that was withdrawn from stock mutual funds in 2011 may be due more to investor discontent and transfers to ETF's than to a liquidation of assets by retirees, these draw downs  are likely a precursor of a trend toward increased redemptions. Further, the weak job market is forcing many of those that are out of work to sell assets to pay their living expenses.

The stock and bond markets are likely to be flat or decline during the next few years. The 6% rate of return that is built into many retirement and 401K calculations is likely to be wildly optimistic. Investors should review their plans for building their retirement accounts using realistic assumptions. 

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