4.4% just isn't enough

The decline in tax-exempt assets managed by the 500 largest U.S. managers of such assets, reported in the May 28 issue of Pensions & Investments, could be a forewarning of key issues money managers and pension executives soon will have to face.

Obviously, the drop of 5.3% in total U.S. institutional tax-exempt assets under management in 2011 is no surprise, given the turmoil in the financial markets during the year. The U.S. stock and bond markets were up for the year — the Standard & Poor's 500 index was up 2.1%, while the Barclays Capital Aggregate Bond index returned 7.8%. But international equity markets had negative returns, a result of the European financial crisis, which affected internationally oriented portfolios. Still, there were other factors, including a maturing of the retirement market.

One issue for money managers, as Kevin Quirk of consultant Casey, Quirk & Associates noted, is they will be competing for a pool of assets the organic growth of which has peaked and probably is in decline. That is because the baby-boom generation has begun to retire and the numbers starting to draw on their retirement plans for benefits will rapidly increase. Money will be flowing out of defined benefit and defined contribution plans at an ever faster rate.

Absent strong equity and fixed-income market returns sparking significant growth in retirement, endowment and foundation assets, the institutional investment management industry will be fighting over a pie that is not growing and might be declining.

What are the prospects of a return to strong equity market returns? Probably not great, as the U.S. runs up to the presidential election and the fiscal cliff of expiring tax cuts, and Europe wrestles with its own fiscal crisis. Longer term, they still are uncertain.

According to an analysis by Christopher Brightman, head of investment management research at Research Affiliates, as of late 2011, the 10-year expected return for the equity market is 6%, the 10-year bond yield is 2% and the expected return for a 60% equity/40% bond portfolio is 4.4%.

He based his projections on research that showed the 8.9% historical annual return on equities between 1871 and 2010 could be explained by the dividend yield, real earnings-per-share growth, inflation and price/earnings multiple expansion.

Over the entire period, the dividend yield provided 4.6% return and real EPS growth provided 1.7%. Over the past century, however, the EPS growth averaged only 1.5%. Multiple expansion over the period provided only 0.3% annual return.

In the report, published in the Investment Management Consultants Association's Investment and Wealth Monitor, Mr. Brightman noted the realized return was sometimes higher than the expected return at the beginning of the period. In 1990, for example, the expected equity return based on dividend yield, EPS growth and inflation was 10% and the realized return at the end of the decade was 14% because of multiple expansion driven by the tech bubble.

However, at year-end 2000, the expected return dropped to 5% and the realized return at the end of the decade was only 4%.

The fixed-income market is unlikely to continue to return 7% a year as yields are historically low and can hardly fall much further. Many analysts expect fixed-income returns to begin to decline as soon as the Federal Reserve Board ends its low interest rate policies.

Pension funds, endowments and foundations have diversified into international portfolios and alternatives such as real estate, hedge funds and venture capital, but almost 60% of total U.S. institutional tax-exempt assets are still invested in domestic stocks and bonds.

If the assets in the 60/40 stock-bond portfolio grow only 4.4% annually over the next decade, managers in these asset classes will find themselves fighting for shares of a shrinking pie as other investment classes are unlikely to make up the difference.

The prospect of low investment returns obviously must concern pension executives as baby-boomer retirements begin to suck assets out of the funds. Returns of 4.4% annually — even if boosted by a third by alternative investments — would still lead to growing unfunded liabilities. If they are to meet their obligations, pension executives must find ways to boost returns, generally by taking more risk, or they will have to reduce benefits or increase contributions.

At present, many fund executives seem to be adopting lower-risk, lower-return approaches; among the asset classes showing growth in assets in 2011 were active domestic bonds, indexed international bonds, real estate investment trusts, inflation-protected securities, convertibles, infrastructure and currency.

Perhaps the investment management industry, pension plan executives and defined contribution plan participants will be bailed out by extraordinary multiple expansion, boosting the returns over the next decade way above the expected return calculated by Mr. Brightman.

But without serious consideration of whether that is likely — given the economic difficulties confronting the nation and the world — that would not be a wise strategy on which to base business or funding decisions.

Pension, endowment and foundation assets growing at 4.4% will not be enough to spark robust total asset growth for investment managers to fight over, or to meet pension obligations. n