Most pension funds and 401(k) calculators assume total returns in the 7–8% range, and sometimes a bit higher. And yet, stocks and bonds—the two pillars for most investor portfolios—are expected to return 5.2% and 2.5%, respectively. Indeed, the return on the classic 60/40 blend of the two is not even 4.5%. With an approximate 3% differential, we have a stark disconnect between these simple “building block” estimates and “required” return rates.2
Are the return estimates wrong? It’s a legitimate question: these return estimates shouldn’t be taken as fact. One client remarked to me many years ago that we know our forecasts are going to be wrong; we just don’t know by how much they are going to be wrong. Can the markets do better than these anemic prospects? Of course! Conversely, can they do worse? Absolutely!
Polly Anna’s Projections
Polly Anna, head of the pension plan for Global Giant Corp., uses “typical” U.S. pension fund assumptions for her required return and asset allocation assumptions. Thus, she uses an 8% required return and the average U.S. pension fund asset allocation, currently 51.9% stocks, 30.3% bonds, and 17.8% in everything else (“alternatives”).3 Because the alternatives are used to seek equity-like returns while diversifying away some of the risk, most of her peers use return assumptions for alternatives that are similar to those of stocks. Using the estimates in Table 1, Polly Anna’s 52/30/18 asset mix has a forward-looking return of only 4.7%.
Viewing a 4.7% return as unacceptable relative to her 8% required return, Polly looks to the return forecast for three principal asset classes to see if she can squeeze more return from her investments.
- Stocks—The first three components are pretty straightforward. The yield is what it is. Not much wiggle room there. The real growth in earnings and dividends has been just under 1% over the past 100 years, though it reached 2% during the second half of the 20th century. Dare we expect more, with a mature economy saddled with unprecedented debt and an aging workforce?4 Maybe inflation resumes, boosting our notional earnings and dividend growth. That’s a dangerous choice because valuation multiples usually falter in the face of inflation uncertainties. So, there’s precious little opportunity to boost our expectations on these three building blocks.
The only remaining assumption is “changes in valuation.” Changes in the value that the market is willing to pay for a dollar of earnings and dividends can have a huge impact on even long-term returns for equity investors.5 The market paid twice as much for each dollar of earnings or dividends just 10 years ago. Maybe we can return to those valuation levels?
Today’s 10-year cyclically adjusted P/E ratio (so called Shiller P/E) is 20. Polly calculated what stocks had done on a subsequent 10-year basis from similar P/E levels,6 and then took the 75th percentile observation, indicating a top quartile outcome from today’s level, as her optimistic projection. This works out to 9.5%, a nearly 4% percentage point premium above our baseline.7 What a relief! Top quartile stock returns from today’s valuation level can get the returns we need.
- Bonds—The starting yield on a core bond portfolio such as the BarCap Aggregate Index is a very accurate predictor of the likely return of the next 10 years, as Figure 1 shows. Even with big changes in yields over the subsequent 10 years, the return doesn’t change much from the starting yield. Why? Rising yields mean falling prices; these all-too-often cancel each other out in bond-land. But there can be modest differences. Polly Anna took all of the differences between the starting yield and the subsequent 10 years of performance and identified the 75th percentile premium of 0.86%. She then added this to the current yield, for a forward projection of 3.35% for core bonds.
- Alternatives—Many investors, keenly aware that returns will be lower than the past 30 years, have turned to alternative categories like hedge funds, private equity, infrastructure, emerging markets, timberland, and so forth, in a quest for equity-like returns and diversification of risk. This eclectic group has a relatively short history, dubious data (i.e. survivorship bias), and a heavy reliance on the most difficult metric of all to forecast—manager alpha. Thus, Polly simply took the 75th percentile 10-year return for the HFRI Hedge Fund of Fund Composite, which equated to 9.4%.8 Even with the boost from survivorship bias, this gets us no better than the top-quartile stock market return. Still, her 8% return assumption does seem within reach.