The writer is a financial journalist and author of ‘More: The 10,000-Year Rise of the World Economy’
Three related questions are at the heart of investment decisions today. What is the risk-free rate of return that investors can now earn? What future return is it reasonable to expect? And what is the prudent level to take or “withdraw” from a pension fund or savings plan? The answers to these questions are relevant to everyone from charitable foundations and giant pension funds to people in their 60s who are thinking about how best to use their fundraiser.
None of these questions are easy to answer. Take the risk free rate. This could be defined as the yield on short-term bank deposits (virtually zero at the time of writing), the yield on two-year Treasury bonds (0.6%) or on 10-year bonds (1.44%) .
All of these factors are very low by historical standards and well below the current inflation rate (6.8% in the United States). Investors seem likely to see the value of their money erode in real terms, and if they sell the bonds ahead of maturity, they stand to lose money in nominal terms as well.
If investors explicitly try to hedge their portfolios against higher prices, inflation-protected 10-year Treasury bonds yield minus 1%, guaranteeing a real loss if held to maturity. As the joke goes, risk-free return turned into risk without return.
The consequences of these very low returns are immense, as other assets are valued based on the risk-free return. For example, companies that borrow in the bond market pay a spread on government bond yields to reflect the risk of default.
As government bond yields have fallen, the cost of corporate borrowing has fallen. Pension funds use the yield on corporate bonds to calculate the cost of paying pension benefits; the lower the returns, the higher the cost of settling future liabilities.
The increase in the book cost of covering pension obligations explains why so many plans are in deficit even though the stock markets have been performing very well since the 2008 crisis. It also explains why many program promoters try to match their obligations. by buying bonds. And in turn, this explains why there are still a lot of bond buyers with very low yields.
Given how unattractive potential bond yields are, it’s no surprise that many investors prefer to rely on stocks. But what return are stocks likely to offer? The standard formula is to add a risk premium to the yield on government bonds. Historically, this has been around 4% globally, according to work by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School. Adding 4 percentage points to the yield on the inflation-linked bond of minus 1% would give us an expected real stock return of 3%.
But do investors really expect equity returns to be this low? It seems unlikely, given how they have piled up in stocks even in the face of the pandemic. Instead, if investors see future returns on stocks as high, that logically means that they expect a very high risk premium to be required from the asset class. In other words, they think stocks are much riskier than normal. Again, this doesn’t appear to be a dominant view.
However, a rule of thumb for markets is that when current valuations are high, future returns will be low. In the United States, stock valuations are very high, as measured by the Cyclically Corrected Price / Earnings Ratio (Cape) developed by Robert Shiller of Yale University, which compares stock prices to average earnings of companies from the last 10 years. The current Cape ratio is 38, a level that was only higher during the peak of the dot-com bubble of 2000.
But if future returns are low, investors face some very difficult decisions. Pension plans will have to ask for more money from their corporate sponsors or, in the public sector, from taxpayers. Individual workers trying to build a pension fund need to save more now and spend less; an approach that governments trying to stimulate their economies may not fully welcome.
Likewise, if future returns are to be low, the pace of withdrawals should also be reduced. Charitable foundations often follow a 5 percent rule when deciding how much income to withdraw from their foundations. It seems too high. Likewise, retirees with pension funds may need to withdraw less than 4 percent per year to ensure that their money does not run out. Investors are bombarded with information about which stocks or mutual funds to choose in the hopes of beating the market. Too little time is spent discussing how much money they should be setting aside in the first place.