Don't hold your breath for returns from pension plans

Serious Money:It is a low-return world. Even the chairman of the Federal Reserve, Ben Bernanke, recently admitted that he took "very seriously . . . the possibility that very low interest rates" could prompt portfolio managers dissatisfied with low returns to "reach for yield".

Unfortunately, such concern is already justified: ultra-accommodative monetary policy has helped push the yields available on both “risk” and “safe” assets to levels that virtually assure lacklustre returns for a traditional 60:40 equity/bond policy mix over long horizons of 10 years or more.

The less-than-inspiring outlook for long-term investment returns is a matter of simple arithmetic, yet much of the investment community continues to cling to the hope that pension plan assets will ultimately deliver satisfactory outcomes for long-term savers.

There are few who dispute that safe assets are likely to deliver sub-optimal returns over long horizons, but many – conditioned by the outsized investment performance of the 1980s and 1990s – continue to argue that the gains on risk assets will make up the difference. These ill-founded arguments are likely to prove wrong.

The fact of the matter is that the rewards generated from traditional asset allocations has been so good for so long that many have come to see high inflation-adjusted returns as some sort of birthright.

An end to the trend

Both global equities and bonds have delivered annualised real returns in excess of 6 per cent over the past 30 years, but current valuations suggest expectations that extrapolate this trend for a traditional 60:40 mix into the future are nothing more than wishful thinking.

Real bond returns have been nothing short of breathtaking over the past three decades, but with twenty-twenty vision, that’s understandable given the starting point and subsequent fundamentals.

Ten-year Treasuries offered a yield of more than 15 per cent in the autumn of 1981, but the disinflationary monetary policy conducted by Paul Volcker during his time at the helm of the world’s leading central bank, saw the yield drop below 9 per cent by the time he was replaced by Alan Greenspan six years later.

Monetary policy that prioritised opportunistic disinflation continued under Greenspan and, by the end of the 1990s, the yield available on the benchmark Treasury bond hovered around 6 per cent.

All told, Treasury bond investors earned annualised real returns of close to 8 per cent during the 1980s and 1990s – the best two-decade performance in all of American financial history.

More was to follow of course, as the disinflationary trend gave way to deflation fears following the southeast Asian crisis in the late-1990s and the collapse of the stock market bubble at the turn of the new millennium, but the biggest fillip to the realised returns on safe assets came with the crisis in structured finance that stemmed from misguided lending in the sub-prime mortgage space.

Treasury yields continued their long journey downwards, and the inadequate recovery in the post-crisis economy ensured that yields remained close to all-time lows.

That remains true today, with the 10-year benchmark bond yielding less than 2 per cent, a level that does not compensate for long-term inflation expectations. This virtually assures that – absent deflation – investors can expect to realise negative real returns in safe US assets over the next 10 years.

Corporate credit

Traditional investors might turn to corporate credit to boost returns, but the story – adjusted for risk – is much the same.

The current spreads for lesser-quality corporate credit imply a real yield of just 2 per cent, and incorporating likely default rates and recoveries suggests that investors can expect to earn even less.

The debt markets provide little optimism for high future returns, so all hope rests on the equity market. Stock returns exceeded all expectations during the 1980s and 1990s and, though equity markets endured a torrid decade during the first 10 years of the millennium, the major market averages still sport valuations well above long-term norms.

Indeed, the stock market’s current dividend yield in combination with long-term real growth suggests investors should expect no more than 3 per cent per annum in real terms – less than half the historic average.

Of course, even this sub-optimal outcome does not take account of the well-known tendency for valuation ratios to mean revert, in which case the most likely annualised real return is closer to 1 per cent or 2 per cent.

It is a low-return world, and traditional policy mixes are unlikely to deliver annualised real returns of more than 1 per cent to 2 per cent over the next 10 years.

The plain facts may well encourage return-chasing, but the astute will keep their powder dry – and remember the words of the late investment visionary, Peter Bernstein: “The market’s not a very accommodating machine; it won’t provide high returns just because you need them.”