6 minute read
Have you ever heard of the wealth effect?
As a financial advisor, I’m sure you might’ve encountered this term before. But in case you haven’t – it’s the theory that people will spend more as the value of their assets rise.
Put simply, the whole concept revolves around the idea that households feel more financially secure and confident to spend when their homes or portfolios increase in value.
For example, if home prices increase by 50%, the owners will feel richer because their costs are essentially the same as before with their locked-in 30-year mortgage. Now, with that extra equity, they may take that Caribbean cruise, or do a refinance cash-out to buy a new car, or whatever else.
The Federal Reserve is also a big proponent of this theory—believing that cutting interest rates and stimulating monetary policy can push asset prices higher, which will create a “wealth effect” and keep people spending and spending.
· To put this into perspective, the Former Federal Reserve Chairman, Ben Bernanke, once wrote1 that, “…lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion."
Seems simple, right? Juice up asset prices, make people confident and keep on spending.
But there’s also a consequence of the wealth effect. . .
And that’s how it spurs earlier retirement.
So, let’s take a closer look at this.
Did The Pandemic-Era Stimulus ‘Wealth Effect’ Trigger A Great Retirement Boom? It Appears So.
Since 2020, there’s been a startling increase in retirement.
There’s an excess of nearly 3 million more retirees than any model forecasted.
To visualize this trend, take a look at the graphic below of excess retirees compared to the Federal Reserve’s predicted path from Bloomberg2 over the last four years.
What caused this gap?
Well, financial market performance seems to have influenced the situation.
For instance, the discrepancy in the model seemed to be narrowing after the S&P 500 experienced a 19% decline in 2022. However, in 2023, the index surged, increasing by 24%, with the majority of the gain occurring in the fourth quarter.
Meanwhile, housing prices continued to rise across the majority of US metropolitan areas in the last quarter, further enhancing the wealth of older Americans.
And to put this into perspective, if we look at the total household net worth level—it’s up a staggering 36.5% between Q1/2020 and Q3/2023 (according to the latest data available).
Figure 1: St. Louis Federal Reserve, Q3/2023 (latest data)
This surge in the wealth effect was quite sharp. And it likely contributed to putting gasoline on the “great retirement boom” fire that began in 2020 as households were more comfortable with their portfolios and assets.
It’s important to note that this wave of retirees will continue for the foreseeable future.
To give you some more context, we have written about the demographic storm hitting the U.S. before—The Perfect Storm: Why This May Be The Most Important Time For A Financial Advisor—with the number of individuals hitting retirement age expected to average around 10,000 to 12,000 per day until 2030.
· In fact, between 2010-2020, we saw the largest-ever 10-year numeric gain in retirees—an increase of 15.5 million people. For context, the next largest 10-year numeric increase was between 1980-1990, and it was less than half that size (just 5.7 million). And this trend isn’t going to change anytime soon.
Now, while higher net wealth is a welcome sign for those looking to retire, it could have some important implications for retirees and their financial advisors in the future . . .
Retirees Depending On The Gains From The Wealth Effect May Need A Prudent Financial Advisor
Just as the Fed juiced up asset prices to help stimulate a wealth effect, it’s important to remember that it could—and likely will eventually—go the other way.
Remember, markets work in cycles. They will boom, bust, and repeat over and over.
Thus, individuals happy with their portfolios may plan to retire sooner rather than later. Or expect prices to keep rising and buy more at lofty prices.
But, alas, prices could revert lower and throw a wrench on those plans—triggering a negative wealth effect. . .
This is especially an issue for retirees who depend on fixed amounts of income from their portfolios to cover retirement spending.
That’s why understanding the concept of "sequence risk" is essential, as it directly affects the stability and longevity of retirement savings.
So, what exactly is sequence risk?
We recently published an in-depth article on this topic—Sequence Risk, What It is, And Why It Matters In A Bear Market For Retirees.
But in essence, sequence risk refers to the possibility that your investments may perform poorly, particularly in the early years of retirement, which could force you to reconsider your retirement plans.
For example, did you know that if your portfolio experiences a 50% decline, it will need to double by 100% just to break even? This highlights why downturns in portfolios can be incredibly detrimental for retirees.
This risk entails the possibility of investors facing negative portfolio returns toward the end of their careers or in the early stages of retirement. And it holds significant importance because retirees require additional time to recover from losses, particularly when compounded by the simultaneous withdrawal of monthly retirement income distributions.
And in an era of the ”great retirement boom,” this could pose a problem for many households that may be extremely sensitive to declining asset prices, potentially forcing them out of retirement.
The Double-Edged Sword Of Wealth Effects
In conclusion, the phenomenon of the wealth effect, spurred by surging asset prices, has contributed to a surge in retirements since 2020.
And this tidal wave of retirees, fueled by increased financial security and confidence, is reshaping the landscape of retirement planning.
However, as markets inevitably cycle and asset prices fluctuate, retirees dependent on the gains from the wealth effect may face unforeseen challenges.
And amid this "great retirement boom," prudent financial advice becomes crucial in ensuring retirees' financial security in the face of potential market downturns and negative wealth effects.
Thus, understanding this empowers you as financial advisors to anticipate client behavior, mitigate risks associated with market fluctuations, and potentially guide them toward making better financial planning decisions.
As we’ve learned time and time again, what goes up likely comes back down. . .
Sources:
1. https://www.federalreserve.gov/newsevents/other/o_bernanke20101105a.htm
3. https://www.stlouisfed.org/on-the-economy/2023/jun/excess-retirements-covid19-pandemic.
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