Whats a reasonable number we can expect when planning our retirement savings?
Often when you sit down with financial advisers to derive a retirement plan they pull out a chart and attempt to explain the return characteristics of various asset classes over the years.
At this time, the little voice in your head should whisper the mantra Prior returns are not indicative of future performance.
Investing, of course, is about the future and not the past. Future returns involve numerous aspects but past returns are not one.
Future prospects are mainly dictated by the conditions present at time of purchase.
The estimated return characteristics of various asset classes are a crucial aspect of all retirement planning and pension funding.
Risk arises when overly optimistic expectations can lead to disappointment and future shortfalls in estimated savings. It is also an important consideration in determining how much you save, or in the case of pension plans, how much money is needed to fully fund the plan.
So what can we expect going forward? What number should we consider when planning our savings?
What conservative estimate could pension plan trustees consider as reasonable when planning future funding needs?
There are many approaches and variations used to determine long-term return forecasts but Im going to walk-through one variety.
To evaluate the opportunity in equities moving forward, we can simply take the sum of the following three variables: expected earnings growth, expected dividend yield, and expected change in the multiples that investors are willing to pay for earnings.
Mathematically, the sum of these three variables equals ones expected total return over a set period of time.
Bond returns are obviously a lot simpler.
You essentially get the rate of return quoted as the yield at time of purchase for the duration you are holding the asset.
Taking these two projected returns and summing their respective weights in your pension or portfolio offers you an expected total return.
Lets first examine the components of equity returns.
Corporate profit growth is highly correlated to nominal GDP growth over time. Although there are a number of pressing issues that the world is facing now such as slowing Chinese growth, the European debt crisis and the US fiscal cliff, economists expect global growth to remain positive over time to the tune of approximately three percent real growth or about five percent nominal.
US growth should muddle along at nominal rate of four percent to five percent.
As a check, US long-term nominal earnings growth has been approximately 4.8 percent (1.7 percent in real earnings per share growth plus a longer term inflation rate of 3.1 percent).
Therefore, its reasonable that we could expect a four percent to five percent earnings growth per year over the intermediate term.
Dividends actually look rather favourable at this juncture as well. Corporate cash levels are sitting at record levels and payout ratios are relatively low.
This offers great potential for further dividend increases over time. Currently the yield on the MSCI ACWI Index (which includes developed and emerging markets) is about 2.8 percent. Real world dividend growth from 1900-2011 was a measly 0.8 percent so we will be conservative and assume dividends add 2.8 percent to our return.
The last factor is always the most controversial. How can we determine what investors are willing to pay for every dollar of earnings. Currently the MSCI ACWI Index trades at a price-earnings multiple of 15.4 times vs. its median value of about 20 times over the past 17 years (as far as data goes back on Bloomberg). Thus there is scope for multiple expansion along the way. Adding up these components we can conservatively estimate longer-term global equity returns of the magnitude of six percent to seven percent without any multiple expansion. Annual returns may be close to double digits if we see some multiple expansion over time as well.
Low current yields virtually guarantee poor nominal returns on bonds at this juncture. Currently the Merrill Lynch Global Broad Market Bond Index yields a paltry 1.74 percent. High quality corporate bonds in the US yield only 3.8 percent.
Depending on ones allocation its unlikely that bond portfolios will yield much more than two percent to four percent nominally over the intermediate term.
Putting it together
Given the range of potential returns described above, its likely that a traditional 60 percent equities and 40 percent fixed income portfolio can generate returns ranging from 4.4 percent to 5.8 percent per year.
Although one might be tempted to simply build a portfolio consisting of the higher estimated return assert class of equities it is likely very unwise to do so. Diversification is still important and asset allocation depends not only on potential return estimates but also an individual or corporations willingness and ability to take risk.
It is with concern that we do note however, that in the US and Bermuda, pension funds continue to expect annual returns on balanced portfolios of seven percent to eight percent which, depending on their asset mix, may be unreasonable.
If you or your pension plan is estimating much higher rates of return theres a risk of funding shortfall. This means unfunded obligations may be understated currently and corporations and individuals will need too, at some stage, increase contributions or expect less in benefits or future value.
Nathan Kowalski is the chief financial officer of Anchor Investment Management Ltd.
Disclaimer: This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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