The asset management business involves its fair share of travel. Mechanical delays, cancelled flights, inclement weather, hotel overbookings, and traffic snarls are just a few of the many things that can get in the way of getting to a meeting on time. But every once in a while, we get lucky—security is a breeze, the flight arrives 20 minutes early, there’s no line at the cab stand, traffic is nonexistent, and the hotel gives us a free upgrade. These rare instances are a blessed welcome.
Of course, it is not prudent to rely on good fortune, planning our itinerary on the basis of everything going right. Suppose we’re planning a very important trip—one that will determine the financial well being of our company and our employees, not just for the next few years but the decades ahead. Most of us would be ultra-conservative in building our itineraries, with contingency plans for anything that might go wrong. We’d arrive not just the night before, but the morning before. We’d FedEx our materials and bring some hard copies with us (not even relying on our computers). We would map out the route, research the traffic, and leave an ample cushion of time for all the potential pitfalls of the journey.
Unfortunately, the return assumptions built into pension and retirement plans today are analogous to our traveler assuming that everything will go right. Hope is now the bedrock of financial planning, discount rates and pension return assumptions, allowing for no disappointments along the way. In this issue we attempt to quantify the hoped-for good luck that is needed for today’s retirement assets to fully cover tomorrow’s retirement liabilities. We discover $16 trillion in assets are, in effect, counting on the plane getting to the gate an hour early, followed by a road-clearing motorcade.
We can’t predict the future with complete accuracy. As physicist Niels Bohr once quipped, “Prediction is very difficult, especially if it’s about the future.” But we can build reasonable starting points by looking at the key components of long-term asset class returns. As we outlined in February, the return for almost any asset class can be broken down into income, growth (real growth plus expected inflation), plus changing valuation multiples.1 These are the “building blocks” of return. Using this simple method and today’s yields, we get the long-term expectations (10–20 years) for stocks and bonds shown in Table 1.
(For a larger view, please click on the graphic above.)
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!