The current economic crisis represents an opportunity for all those responsible for investing retirement funds to re-examine some of the key assumptions underlying their investment strategies.
Possibly the first assumption that should be reconsidered is the assumed long-term rate of return on the investment portfolio. That involves re-examining the expected long-term rates of return on the various asset classes.
Can equities still be expected to produce a compound annual real return over the long run of 8%, given the current outlook for slow economic growth for the foreseeable future?
For the two decades after the stock market collapse of 1929 and the Great Depression, the stock market languished and produced real returns of just 5.6%. Could it do so again after the Great Recession?
What is likely to be the long-term return on fixed-income portfolios, given the current low interest rates, the potential for deflation, and the same slow economic growth outlook? When interest rates next move up, the return on bonds will be negative, and that could last for years, especially if inflation develops and persists.
What is a reasonable return expectation for real estate investments, for venture capital and private equity?
How much of the slack can hedge funds be expected to pick up, and how much of any retirement fund can prudently be invested in hedge funds?
The answers to these questions have significant implications for the long-term funding of the pension obligations.
For too long many pension sponsors, especially defined benefit plan sponsors, have used the healthy expected return assumptions to justify minimal contributions to the plans. If realistic analysis suggests long-term rates of return will be lower in the future, then contributions will have to be greater.
Robert D, Arnott, chairman of Research Affiliates LLC, and the late Peter L. Bernstein won the Graham and Dodd Award for excellence in financial writing in 2002 for a paper in which they argued equity risk premiums were too high, and could not be sustained long term.
Unfortunately, they were six years too early, and few heeded their warning.
The prudent pension fiduciary will use the current financial crisis to look at the Arnott and Bernstein analysis — and a similar one by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School done about the same time — and consider if the assumptions used in their funds are still valid.
If not, they should change them.
Those overseeing defined contribution plans likewise should re-examine the materials they supply to plan participants to see if the information on long-term rates of return is realistic.
If long-term expected returns will be lower, employees will have to be encouraged to contribute more, and companies might have to provide more generous matching contributions. n