LONDON Dec 13 What if 3 percent is the new 8 percent?
Institutional investors such as pension funds have typically built in return assumptions of 8 percent a year - a rate some of them have not achieved for more than a decade.
Faced with slower economic growth across the world, some are cutting these long-term assumptions for the first time in a quarter of a century, with potentially far-reaching implications for pensioners, savers and asset managers.
Since the world entered what PIMCO dubbed the New Normal or slower economic growth in 2009, investors have had a relatively easy time making money thanks to cheap cash from central banks fuelling virtually all asset prices. This year alone benchmark world stocks have gained 15 percent.
But even with that, large investors, especially pension funds, have failed to achieve the 8 percent target, partly due to high fixed income holdings which returned very little.
According to the OECD, the weighted average real net investment return of pension funds which manage combined assets of over $32 trillion was 4.4 percent in 2012, and just 0.2 percent in the year before.
U.S. public pension funds, which have been increasing the share of equities in their portfolio, made an average quarterly return of 3.45 percent in the first nine months of 2013, based on data from Wilshire Associates. Wilshire's data shows the median return was 5.2 percent over the last five years.
Their score is rather disappointing, even in the investor-friendly environment of the past few years. Looking ahead to 2014, the 8 percent return target looks even less achievable, especially as the Federal Reserve starts to scale back bond buying.
"We're starting to pivot away from sugar highs from all the central bank policies to more underlying economic growth which will determine investor returns. Investors need to recalibrate as a result their asset allocation," said Alexander Friedman, global chief investment officer at UBS Wealth Management.
Friedman forecasts equities will return about 7-8 percent annually over the next three to five years.
"Now that's a pretty decent return but it's not the 15 percent annual return we saw over the last five years," he added. "Over the last five years, returns in equities were not driven by underlying economic growth, they were driven by unconventional monetary policy which is now on a path to normalisation."
UBS recommends a strategic portfolio to include corporate bonds, high yield and emerging debt as well as equities to maximise returns over the next five to seven years.
Pension funds, especially public ones in the United States, typically use the 8 percent target - used to calculate contributions they need to cover future payouts - because it is the median annualised investment return for the past 25 years.
But already underfunded and facing increasing liabilities from ageing populations, pension funds will have even bigger deficits if they cut the return estimate. This means retirees will get lower payouts, or plan sponsors must pay more now.
Some pension funds are indeed facing up to the reality and cutting their return estimate. Calpers, the largest U.S. public pension plan, cut its assumed rate of return to 7.5 percent from 7.75 percent last year.
According to data from Washington-based think tank Pew Center, the U.S. state pensions achieved just 4 percent on average between 2000 and 2009.
PARADOX OF WEALTH
Ben Inker, co-head of asset allocation at U.S. manager GMO, says real equity return assumptions may have to come down to 3.5 percent, as opposed to the 43-year average of 5.7 percent on the S&P 500 index.
"The U.S. stock market is trading at levels that do not seem capable of supporting the type of returns investors have gotten used to receiving from equities," Inker said.
A more worrying long-term picture is painted by American financial theorist William Bernstein, who says increasing levels of wealth associated with economic growth drive down the return on capital across the global economy.
Bernstein's view, known as the "Paradox of Wealth", is this: in early agrarian societies the cost of capital was high as the rich farmer could lend his grain at a very high rate of interest. For example, a bushel of wheat was paid twice over at harvest time, for a 100 percent return in less than a year.
As a society becomes more productive, wealth slowly spreads among those with grain, domesticated animals and money to spare, and capital becomes more plentiful.
"As societies get richer, the supply and demand equation shifts in favour of capital's consumers," he writes in a paper.
Based on energy consumption and cost of capital, Bernstein estimates a theoretical real investment return of 125 percent in prehistoric periods.
In ancient Mesopotamia and Greece's more advanced societies, interest rates fell to low double-digit levels; by the height of the Roman Republic and Empire, prime interest rates hit as low as 4 percent. Today, it is just 2 percent, he says.
"Both theory and long-run empirical data support the notion that economic growth lowers security returns; such is the price of living in an increasingly prosperous, safe, healthy, and intellectually gratifying world," Bernstein writes. (Editing by Catherine Evans)