Tuesday, May 29, 2012

Can Stocks Earn Annual Returns of +10% In the Coming Years?

Sunday's New York Times carried a front page article "above the fold" about the perilous state of our nation's public pension plans.

The article highlighted the fact that the actuarial rate for most pension plans assumes investment returns in the 7% to 8% range.

However, returns for most plans have been well below this range; the pension plan for New York State, for example, earned slightly less than 6% last year.

Corporate pension plans, by comparison, are currently assuming returns less than 5%.

Changing the assumed rate of return on public pension plan to a more realistic figure is not as as simple as it might seem.  The lower the assumed rate, the more taxpayer contributions are required to make up the shortfall, which is obviously not a message that most politicians want to deliver.

Still, at some point a little honesty seems appropriate, as New York City Mayor Bloomberg noted:

“The actuary is supposedly going to lower the assumed reinvestment rate from an absolutely hysterical, laughable 8 percent to a totally indefensible 7 or 7.5 percent,” Mr. Bloomberg said during a trip to Albany in late February. “If I can give you one piece of financial advice: If somebody offers you a guaranteed 7 percent on your money for the rest of your life, you take it and just make sure the guy’s name is not Madoff.” 

http://www.nytimes.com/2012/05/28/nyregion/fragile-calculus-in-plans-to-fix-pension-systems.html?_r=1&src=me&ref=general

Part of the problem for the public plans is asset allocation.

The response of the public pension plans to the financial turmoil of the past few years has been to reduce the risk profile of their investments.

According to Boston College's Center for Retirement Research, the average allocation to fixed income among public plans in the U.S. is almost 30%, while stocks average less than 50% nationally.  Alternative investments - such as private equity and real estate make up the rest.

http://pubplans.bc.edu/pls/apex/f?p=1988:12:1473440180402201:pg_R_420673752751727939:NO&pg_min_row=21&pg_max_rows=20&pg_rows_fetched=20

The average yield to maturity of the Barclays Aggregate Bond Index - which encompasses the entire investment grade corporate bond universe, plus mortgage-backed securities and U.S. Treasury obligations - is 1.74%.

If you have roughly one-third of your porfolio yielding less than 2%, this implies that the remaining two-thirds has to earn nearly 10% in order to come up with a blended rate of 7%.

And while I am generally positive on the outlook for stocks in the coming years, I would note that periods of 10% compound returns from equities are relatively rare.