Monday, March 26, 2012

Pension Plans: What Might They Earn in the Stock Markets?

Most pension plans, both public and private, aim for an annual return on investment of about 7.5-8.0% in order to cover their anticipated future outlays. There has been considerable discussion as to whether that is an attainable goal. Most pension plans were initiated in periods when that level of return was reasonable, but that does not necessarily have relevance to the current and future environments.

Many pension funds have traditionally followed the advice given to individual investors: diversify the portfolio and include a small fraction of fixed investment securities to balance the more volatile investments in stocks. The yields from the two types of investments are not unrelated, but generally, stocks have fared better.

Those who like to try to quantify economic facts and relate them to some fundamental concept have come up with a quantity referred to as the "equity risk premium" to define the greater yield observed with stock investments relative to government securities for example. An article in The Economist provides a discussion of this quantity.

"The long-term faith in equities is based on the theory that investors should be rewarded for the riskiness of shares with a higher return, known as the "equity risk premium" (ERP). That risk comes in two forms. The first is that shareholders get paid only when other claimants on a company’s cashflow, such as workers, the taxman and creditors, have received their due. Profits and dividends are thus highly variable and can disappear altogether when times get tough. The second risk is that share prices are volatile, more so than bond prices."

The article provides this chart comparing the ERP over the twentieth century with that observed thus far in the twenty-first.

Equities have historically outperformed government securities by 4-6%. At first glance it might appear that stocks have recently become a bad investment, and there is more money to be made in government securities. While there is some truth to that claim, the situation is more complicated.

Consider the behavior of long term interest rates as expressed in the yields of US government securities.

Investing in these bonds would have been a good investment at almost any time in the past 30 years. The yields have been trending steadily downward. This means any previously purchased bond would have a yield higher than the current rate of return, which is a good thing, but more importantly, the market value of the existing bond will increase as interest rates fall. This has made fixed-interest bonds excellent investments.

This period of falling interest rates has coincided with a largely flat period of growth in stock values over the last decade—thus the negative ERP observed.

Given that we are interested in what earnings pension plans might accrue over the next few decades, we cannot necessarily base projections on the current situation.

The article’s author provides us with additional background. Reference is made to a study of the contributions to the historical ERP.

"The dividend yield comprised the vast bulk of the return. This was true across all the countries studied by the authors. Had investors consistently bought the highest-yielding quintile of equity markets over the past 112 years they would have earned an average nominal annual return of 13.3% compared with a return of just 5.4% for those buying the lowest-yielding quintile. High-dividend markets have also performed best so far this century."

This study indicated an average dividend return of 4.1% over the period 1900-2011. The observed dividend return in recent years is estimated to be 2.7% (worldwide). Could the currently lower dividends be an effect of stock price stagnation—or a cause of it?

"The importance of the dividend yield is ironic, given the lack of focus on the measure in most modern investment commentary. Many analysts argue that the dividend has been superseded by the share buy-back which (particularly in America) is a more tax-efficient way of returning cash to shareholders."

Could this be a case of economists, and their corporate counterparts, foolishly assuming that investors are rational beings? While a stock buy-back will drive up the price of shares—usually—the gain could disappear in the bat of an eye. On the other hand, a dividend check is forever. Investors are also smart enough to know that stock buy-backs benefit most those who consider shares as income (like corporate executives) rather than those who view stocks as a long-term investment (prospective shareholders).

There is a calculation that can be found here that projects stock returns backwards in time given the average common stock price change and an assumed dividend yield. A return of 2% was assumed, a value rather consistent with current times, but too low for earlier periods.

If one chooses to extrapolate the recent past to predict the future, then perhaps integrating over the last 20 years is a reasonable strategy. That would suggest a return of about 4.6%. A higher dividend level would increase that number.

Let us now return to the subject of pensions and their target returns. These plans should have made a fine profit on bonds due to the high interest rates of the past. That is a situation that cannot be duplicated in the future. Let us consider a conservative fund with one-third of its assets in government securities (yielding 3.6%), and the remainder in equities. To reach a goal of 8% return, the fund would have to accrue 10.2% on its equity investments—a rather dubious outcome given the recent past.

The author of the article references another attempt to estimate future equity returns.

"In another paper, Cliff Asness of AQR Capital, a hedge-fund group, uses his estimates of dividend yield and likely dividend growth to come up with a forecast for future real equity returns in America of around 4% a year."

One struggles to find estimates of returns on investment that can be consistent with the expectations of the pension plans. Of course this conclusion relates to traditional investments.

There will be more on pensions in the near future.

1 comment:

  1. Hello Friends.........

    Great information.Thanks for sharing this useful information with all of us.Keep sharing more in the future.

    Have a nice time ahead.



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