In the midst of record investor bullishness it seems somewhat rude to sound a note of caution. However rising equity valuations and historically (still) low bond yields make it difficult to see how many institutions can meet the returns assumptions they have made public.* This NASRA report shows that the median pension fund is using a 7.5% expected return going forward.
Ben Carlson at A Wealth of Common Sense has done a good job showing how simple 60/40-type portfolios have historically beaten what most people consider the ‘smart money, i.e. college endowments. The problem for institutional investors is that the 60/40 portfolio is facing some tough headwinds.
Michael Batnick in a post at The Irrelevant Investor notes that the demise of the 60/40 portfolio has been written before. However a a closer look at the potential for a 60/40 portfolio going forward looks grim:
Assuming bonds give you 3% for the next decade, then stocks have to give you more than 16% a year to match the returns of the last nine years. This seems unrealistic, to put it mildly. The good news is that there is a universe beyond the S&P 500 and Barclay’s Agg, and there are sensible strategies outside of buying and holding. The bad news is that, well, for the 60/40 portfolio, this is probably as good as it gets.
Unfortunately pushing into alternative investments won’t help, any if at all. Hedge funds, as a whole, have done their best work during periods of market stress. Private equity generated its best returns when equity valuations were low and asset under management were still at reasonable levels. From the Economist:
The Centre for Retirement Research conducted a study* of the effect of investing in alternative-asset categories on state and local-government pension-plan returns in the 2005-15 period. It found that schemes that placed an extra 10% of their portfolio in private equity and property had marginally increased the return on their portfolios (by around a sixth of a percentage point). But investing in commodities or hedge funds had reduced returns, with the latter knocking half a percentage point off the total.
No matter how you read the above it is difficult to see how alternatives can bail out a pension or endowment fund from unrealistic return assumptions and difficult market math.Fortunately (or unfortunately) the logic of the financial markets does not yield to rhetoric or political will. Jason Zweig at WSJ asks why do pension funds still hang their hat on unrealistic return assumptions? Zweig writes:
Because they have to, the chief investment officer of a large public pension plan tells me. State laws guarantee generous retirement benefits for millions of current and former government employees. To appear as if they can meet those obligations, the pension plans have no choice but to set their expected returns higher than reality is likely to deliver.
That’s the exact opposite of what the rest of us should do. Sooner or later, investors who build their expectations on hope rather than on arithmetic end up sorry.
The financial markets don’t care what politicians say, whether it be their pension return assumptions or late night tweets lashing out at companies that fail to adhere to the President’s wishes. State pension funds have to mix politics and investing. Fortunately you the individual investor don’t. Your state government is reluctant to up its contributions to its pension fund. You as an individual CAN increase your savings rate and retirement fund contributions.
Leave the debate over returns assumptions to the politicians. Control what you can, let the markets do what they are going to do, and focus on the long run.
*In regards to the equity market I will point you to this piece by Jesse Livermore at Philosophical Economics. Suffice it to say that it is difficult to conjure a case for US equities, going forward generate returns much in excess of 6%.