What is a realistic long-term rate-of-return assumption to use in planning for your clients? Whatever the answer, this is not a decision that should be put on auto-pilot. Each year, advisors should review with each client a portfolio return assumption that seems realistic and attainable, given current conditions and the client's asset allocation.
Large U.S. pension funds are in a quandary because they have chosen overly-optimistic return assumptions, averaging about 8%, and funding pressures are making it difficult to reduce the rate to more reasonable levels. The largest U.S. pension fund, the $300 billion California Public Employees' Retirement System, is deep into a review process that ultimately may reduce its assumption from 7.5% to 7.25%.
CALPERS argues that 7.5% is not unrealistic because it has achieved a 7.6% average annual portfolio return over the past 20 years.
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However, there are two big differences between now and 20 years ago: 1) The U.S. economy is not sustaining the same rate of economic growth, which will impact equity returns; and 2) 10-year Treasury yields are near a record low, half of what they were 20 years ago, which will create a headwind for bond returns.
Why is the long-term return assumption important? For pension funds, an unrealistically high assumption means they can contribute less each year than they will need to meet future pension obligations. For your clients, it may mean saving and investing too little, while counting on future investment market strength too much.
So, what assumption is realistic?
In its 2014 Long-term Capital Market Return Assumptions, J.P. Morgan Asset Management assumed the following over a 10-15 year horizon: U.S. inflation rate of 2.25%; U.S. real GDP growth of 2.5%; U.S. long-term Treasury return of 3.25%; and U.S. large cap equity return of 7.5%. The only large asset class with a higher assumed return was emerging market equities at 9%.
A conservative long-term assumption for a 60-40 blend of stocks/bonds might be around 5.5% to 6.0%.
However, if the client can commit a sizeable allocation to emerging market equities, the assumption could be a bit higher.
Interestingly, JP Morgan does not assume hedge funds will outperform U.S. equities over the next 10-15 years.
This month, Calpers announced that it is divesting all $4 billion of its in hedge fund investments because they are too expensive and complex and their long-term performance has been under-whelming.
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