The Gloomy Outlook for Returns & Pension Funds

This research note was originally published by the CFA Institute’s Enterprising Investor blog. Here is the link.

SUMMARY

The outlook for US equity and bond returns is low based on historical data

The return assumptions of US public pension funds are difficult to achieve

Only an extreme allocation to alternatives would meet the expected rate of return

THE GLOBAL PENSION FUND CRISIS

Tens of thousands of Dutch workers took to the streets in the spring of 2019 to protest a proposal to raise the retirement age. Then, in October, the two largest Dutch pensions funds, ABP and PFZW, warned that their funding ratios were too low and that they would have to cut pension benefits for millions of retirees. This triggered tense discussions between the pension funds, an alarmed government, and enraged trade unions.

Yet the Dutch pension system is among the best-managed in the world, and both ABP and PFZW are in enviable positions with funding ratios of approximately 90%. Other countries have it much worse. The situation in some US states is particularly grim: The public pensions of Kentucky, New Jersey, and Illinois, for example, all have funding ratios below 40% and are effectively irreparable.

To make matters worse, the current return assumption for the average US public pension fund is 7.25%, according to the National Association of State Retirement Administrators (NASRA). Such a figure is overly optimistic in a low-interest rate environment. And if the return expectations are unrealistic, that means the liabilities and funding deficits are even larger.

So what is the true outlook for returns from US equities and bonds based on historical data? And what needs to happen to achieve the 7.25% return assumption?

THE LIFE AND DEATH OF THE 60/40 PORTFOLIO

A traditional equity-bond portfolio, commonly called the 60/40 portfolio based on its allocations, has served US investors well over the last few decades. But those salad days, with their secular bull markets in both stocks and bonds, are likely coming to an end. It’s not hard to see why.

Bonds have declined consistently since the 1980s and generated attractive returns for investors. But the bond yield at the time of purchase – the starting bond yield – largely determines the nominal total return over the next decade. So what you see is what you get. With current bond yields at approximately 2%, the fixed-income portion of the portfolio is unlikely to generate the type of returns that it has in the past.

Bond Returns versus Starting Bond Yields in the US