At the start of this year—before the coronavirus pandemic gripped the world—BNY Mellon Wealth Management told its clients they should expect a future of lower returns over the coming decade.
The fundamental reason? “The largest economies in the world are all aging,” says Catherine Keating , CEO at BNY Mellon Wealth Management, pointing to Europe, China, Japan, and the U.S.
When economies age, growth tends to fall, yield curves between short- and long-term rates tend to flatten, inflation tends to go down, and “we see lower equity market returns,” Keating says.
In fact, she adds, these trends have been happening since the start of the 21st century. The S&P 500 stock index recorded double-digit returns in the ’80s and ’90s versus single-digit returns in the last 20 years.
The dramatic change this year was, of course, brought on by the pandemic, and the U.S. Federal Reserve’s decision to cut short-term rates by 1.5 percentage point in March. While BNY Mellon expected rates to be low, they didn’t expect the hit taken this year.
That means the trends the wealth management firm identified at the beginning of the year have accelerated. For the high-net-worth and ultra-high-net worth families that BNY Mellon works with, this shift requires taking a look across five areas: investing, borrowing, spending, managing taxes, and protecting wealth.
Low Rates and Investing
Typically, BNY Mellon and other wealth managers will recommend investors have a portfolio of 60% equities and 40% fixed-income that is diversified to include both U.S. and non-U.S. securities as well as small-cap and large-cap stocks. That mix reliably generated returns of more than 7% a year in the last decade, Keating says.
Sticking with that mix going forward is likely to generate an annualized return of less than 5%, she says, with half the decline coming from stocks and half from bonds.
“What do we do? Well, we have to adjust the traditional 60/40 to augment returns going forward,” Keating says. “Every client is different, but we think it looks more like 65/35 for starters.”
The adjusted mix should generate a return of more than 5%. That will happen, Keating says, by adding more private equity, real estate, and hedge fund investments, and decreasing fixed income. Municipal bonds—often popular because of their tax-free status—have an expected total return now in the neighborhood of 1.5%.
Also important is for investors to keep an eye on their goals and to stay invested. “That’s the first pillar—getting the portfolio right and sticking with it,” Keating says.
Borrowing and Spending
While investing in a low-rate environment is challenging, it presents opportunities for those who borrow. Think about a potential homeowner who would have paid a rate of 10% or more on a 30-year mortgage at the beginning of the 1990s. As of the end of September, the 30-year mortgage rate was under 3%, according to data supplied by BNY Mellon.
While the firm’s clients don’t have to borrow, “neither do tech companies flush with cash,” Keating says. “They do it because it makes sense from a capital allocation perspective.”
Simply, clients can potentially benefit from borrowing at low rates and investing the proceeds into securities that generate a higher return. Borrowing 20% against an investment portfolio, for instance, could augment an investor’s return by 15% or 20% over time, she says.
“We help clients think strategically about their balance sheet, their capacity to borrow, their comfort with borrowing, and how borrowing might help them augment their investment returns over time, by staying in the market, or having more in the market,” Keating says.
Clients also have to think about their rate of spending in a low-return, low rate environment. “How much you spend has a huge amount of impact on long-term returns,” she says.
Managing Taxes and Protecting Wealth
Wealthy clients also have to pay attention to how to manage their after-tax returns, particularly amid low rates. While returns for muni securities may be relatively low, they offer more return than Treasuries, for instance, on an after-tax basis.
“We think you can add half a percent a year to your returns over time just by managing for after-tax returns,” Keating says.
And finally, among several practices BNY Mellon recommends clients consider for protecting their wealth—everything from cybersecurity to life insurance—is proper estate planning. And low interest rates are creating opportunities for clients to pass more money on to the next generation.
One reason is that split-interest trust vehicles for transferring wealth are based on a government-set rate. “If your investments earn more than that assumed government rate, that excess passes to heirs without additional tax,” Keating says.
Today, that rate is 0.40% (down from about 7.5% at the beginning of the year 2000), meaning, investment income earned above that level can be passed on tax-free through these vehicles, which include charitable remainder trusts, gift annuities passed on to alma maters, and grantor retained annuity trusts (GRATs).
“There’s a real incentive to employ these strategies now,” Keating says.
The other way families pass on wealth is through loans—a strategy that allows for wealth transfer that doesn’t use up the lifetime gift tax exclusion of $11.58 million per individual in the U.S. To qualify, the client, as a lender, has to charge interest typically based on a government loan rate. Those rates are as low now as 1.12% for a loan with a term of more than nine years.
“There are tough things about low rates,” Keating says. “The yield on your portfolio will be lower, the total return of your portfolio will be lower. But, it’s a good time to be a borrower, and a good time to be an estate transferer.”