Long-term stock returns could plunge to 7% a year over the next 20 years, experts warn.
For the past 10 years, stocks have returned 17.3% compounded annually; for the past 73 years, 11.2%.
When compared with these returns -- and the average pension fund's investment return assumption -- the expected 7% return is anything but great. According to Watson Wyatt Worldwide, pension funds are using an average return assumption of 8% to calculate their liabilities.
Simply put, if actual returns fall below the assumed rate of return, pension funds are in trouble. Funding levels would decline, and plan sponsors would have to make up the investment return shortfall by increasing employer contributions.
Also, pension plans would need to assume higher levels of risk to eke out decent returns.
Jeremy J. Siegel, a finance professor at Wharton School of the University of Pennsylvania, Philadelphia, and author of "Stocks For The Long Run," and David Brief, principal at Chicago-based Ennis, Knupp & Associates, both predict that over the next 20 years, U.S. equity returns will fall below the historic average annual return of 11.2%.
Mr. Siegel predicts a real return of 5% to 7% for the stock market over the next 20 to 30 years, which he said will not be impacted by inflation. He predicts 30-year Treasury bonds will produce a 3% real return.
Mr. Brief predicts a drop in the spread between stocks and bonds and in the equity risk premium. He forecasts the same stock returns, and nominal bond returns, as measured by the Lehman Intermediate Aggregate bond index, of 5% to 6%. The indexes returned 23.4% and 7.9%, respectively, for the year ended Dec. 31.
Meanwhile, Wilshire Associates Inc., Santa Monica, Calif., has lowered its expectations for average annual Standard & Poor's 500 stock index returns to an annualized 8.75% over the next 10 years, down from 11%.
"The historical gap that has existed in the last 50 to 75 years between stocks and bonds is closing," Mr. Seigel said.
In the long run, he believes, returns on stocks will continue to be more stable than returns on bonds. But pension plans, he said, will likely need to change their return assumptions rather than their asset allocations. Allocations to international stocks may help boost long-term gain, even though the asset class carries higher risk, he said.
"I think every day is a new ball game, that's why we think we need to look at the clues in the market today," rather than past return, Mr. Brief said.
Mr. Brief's strategy involves adding his predictions for overall economic growth (3%), dividend yield (2%) and inflation (2%) to come up with a 7% return for stocks. A test of his formula against historical market returns showed that it works, he said.
Ibbotson Associates' statistics over the past 73 years show that large-cap stocks have had average annual returns of 11.2% and long-term government bonds, 5.3%.
Roger Ibbotson, president of Ibbotson Associates, Chicago, and professor in the practice of finance at Yale School of Management, doesn't see the gap between stocks and bonds narrowing anytime soon. He will not lower expectations for the stock market, he said, adding it is not unreasonable to consider historical models when looking at performance.
"I'm reluctant to say the markets are overpriced right now," Mr. Ibbotson said.
The 1,000 basis-point equity premium over bonds in the past 10 years alone has paid off for pension funds, Ennis Knupp's Mr. Brief said. But those days are over, and the spread has shrunk to 100 to 200 basis points.
Mr. Brief's advice to pension executives: diversify. Pension funds need to add balance between growth and value styles and to add non-U.S. stocks to their portfolios to offset risk.
Jay Kloepfer, director of capital market research at Callan Associates, San Francisco, said Callan has lowered its expectations for large-cap stocks in the next five years.
"There's no earnings out there," he said.
Mr. Kloepfer advocates increasing international equity and decreasing domestic bonds for public plans that may have high assumptions but want to decrease the risk in their portfolio.
Corporate plans will need to be more cognizant of their equity exposure, which has crept up as a result of the bull market. Funds with 80% stocks and 20% bonds may want to rebalance back to a 70-30 asset mix, taking mainly from large-cap equity portfolios, Mr. Kloepfer said.
But Steve Nesbitt, senior vice president and principal at Wilshire, does not predict asset allocation changes stemming from the less promising future for stocks.
One fund says no
But not every pension fund is buying what their consultants are saying.
The $430 million pension fund of the Board of Public Utilities of Kansas City, Kan., rejected consultant DeMarche Associates' recommendations to add emerging markets and junk bonds, said George Dalton, pension administrator.
"The logic doesn't seem to be there," he said.
The fund had a good year in 1998, he said, gaining $20 million, and trustees don't think the fund needs to assume more risk.
The fund's current asset allocation is 60% equities, 20% bonds, 5% cash, 10% international equities and 5% real estate.
Mr. Dalton remains optimistic but does admit that sooner or later the gap between stock and bond performance will narrow.
Michael Bostler, senior investment consultant at Alpha Investment Consulting, Milwaukee, said he doesn't expect asset allocation changes, nor does he expect stocks to plummet from double-digit returns, as long as cash flows and liquidity continue.
"The more money you put into stocks, the more you will have 20 years from now. That's not 18.2%, but anyone that tells you 18.2% is just guessing anyway," he said.