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The Analyst

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.


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


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?


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

Source: FactorResearch. Bonds returns are represented by the Vanguard Total Bond Market Index Fund (VBMFX) and bond yields by a combination of US 10-year Treasury notes (70%) and US corporate investment-grade bonds (30%).

The relationship between valuation and subsequent returns is not as statistically meaningful for equities as it is for fixed income. Stocks only have a 0.55 correlation compared to 0.97 for bonds. Nevertheless, historically the lower the earnings yield – calculated as the inverse of the cyclically-adjusted price-to-earnings ratio (CAPE) – at the time of the investment, the lower the subsequent returns.

But as emerging economies become more technologically driven and different accounting standards are adopted, older valuation data may lose some of its relevance. While slightly higher valuations may be justified, these still mean-revert over time.

The current earnings yield of 3.3% equates to a CAPE ratio of 30, which is expensive even in light of recent history, and suggests low returns for US equities over the next 10 years.

Equity Returns versus Starting Earning Yields in the US

Source: Robert Shiller, FactorResearch.

By combining the expected returns from equities and bonds based on historical data, we can create a return matrix for a traditional 60/40 portfolio. Our model anticipates an annualized return of 3.1% for the next 10 years. That is well below the 7.25% assumed rate of return and is awful news for US public pension funds.

Subsequent 10-Year Annualized Return for a Traditional Equity-Bond (60-40) Portfolio

Source: FactorResearch.


If US equities can’t deliver the required returns, where can pension funds go? With low- or negative-interest-rate environments in much of the developed world, international bonds aren’t especially appealing. So what about international and emerging market equities, real estate, hedge funds, and private equity?

Large asset managers provide 10-year return assumptions for various asset classes. We aggregated this data from a number of firms and found that almost every asset class is expected to outperform US equities and bonds.

Of course, these expected returns should be treated with severe caution for several reasons:

Forecasted asset prices are highly unreliable.

The Analyst

About Nicolas Rabener

Nicolas Rabener

Nicolas Rabener is the Managing Director of FactorResearch, which provides quantitative solutions for factor investing. Previously he founded Jackdaw Capital, an award-winning quantitative investment manager focused on equity market neutral strategies.

Articles by Nicolas Rabener

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