LONDON (Reuters) - Investment behavior, jobs and growth hinge on assumptions about the long-run returns and risks that investors should expect, and these expectations rarely budge, even when they become inappropriate or unrealistic.
“The most stable and least easily shifted element in our contemporary economy has been hitherto, and may prove to be in future, the minimum rate of interest acceptable to the generality of wealth-owners” John Maynard Keynes wrote in 1936 in his landmark “General Theory of Employment, Interest and Money”.
“The rate of interest is a highly psychological phenomenon,” Keynes claimed. He worried that the experience of the previous 150 years had accustomed investors to expect a long-run interest rate of 5 percent but that it might not always be realistic or appropriate to full employment and reasonable economic growth.
The rate of 5 percent reflected the prevailing balance of social and economic forces, according to Keynes. “The growth of population and of invention, the opening up of new lands, the state of confidence and the frequency of war ... taken in conjunction with the propensity to consume ... allowed a reasonably satisfactory average level of employment to be compatible with a rate of interest high enough to be psychologically acceptable to wealth-owners.”
But turning to the conditions prevailing during the Great Depression, Keynes worried: “If a tolerable level of employment requires a rate of interest much below the average rates which ruled in the nineteenth century, it is most doubtful whether it can be achieved merely through manipulating the quantity of money.”
The stubbornness of expectations about interest rates and returns lies at the heart of Keynes’ theory about why the economy could settle below full employment. It was why he advocated “euthanasia of the rentier” (the investor demanding real return without shouldering real risk). It underlay his call for the government to step in and undertake investment when firms and the private sector were unwilling to invest to ensure full employment of resources.
Something similar has happened in the wake of the current crisis. Last week, my colleague Edward Hadas wrote a fascinating column exploring the damage done by stubbornly high hurdle rates for capital investment.
According to Hadas, unrealistic expectations have fuelled excessive risk-taking among financial institutions as decision-makers struggle to meet high targets by loading up on (hidden) risk. Meanwhile resource companies and other firms have refused to commit to otherwise profitable investments, because projected returns were not high enough to meet fantastic investment criteria.
Hadas reports how many managers have resorted to innovative accounting to solve the problem, creating excessively optimistic cash flow projections to meet their excessively optimistic investment thresholds, although that simply changes the timing of when the disappointment is recognized.
Now after years of underperformance against unrealistic targets, there are signs that at least some decision-makers and investors have begun to revise them in a more sensible direction, albeit slowly and haltingly.
In the United Kingdom, the Financial Services Authority (FSA) has started to consult on reducing the projection rates that money managers must provide investors when they buy a retail investment product such as personal pension or a life insurance policy. The projection rates are meant to give them a rough but realistic expectation of how their investment might grow over time.
At the moment, investors must be shown three illustrative annual growth rates - a low rate capped at 5 percent, intermediate at 7 percent and high at 9 percent. Investment managers can show lower illustrative rates but not higher ones.
Projection rates were last reviewed in 2007. Following a peer-reviewed study by PricewaterhouseCoopers, however, the FSA proposes to cut the intermediate projection by 2 percentage points to 5 percent, reflecting the diminished outlook for returns, and widen the range of uncertainty from 2 percentage points to 3 (“Rates of return for FSA prescribed projections” Apr 2012).
If the proposals are adopted, investors in tax-advantaged products would be shown projection rates of 2, 5 and 8 percent, rather than the current 5, 7 and 9 percent. Non tax-advantaged products would have illustrative rates half a percentage point lower (“Product projections and transfer value analysis” May 2012).
In the United States, most public employee retirement systems still target much higher nominal returns, typically at least 7 percent and in many cases 8 percent or slightly higher. The median assumption for 126 systems covered in the National Association of State Retirement Administrators (NASRA) annual Public Fund Survey is 8 percent.
But in March, the California Public Employees Retirement System (CalPERS), which is the largest U.S. public fund, trimmed its assumed discount rate from 7.75 percent to 7.50 percent. CalPERS’ rate had remained stable since being cut from 8.25 percent 10 years ago. The reduction reflected a fall in expected inflation from 3 percent to 2.75 percent, rather than the assumed real rate of return, which remains at 4.75 percent and still looks high.
Other retirement systems have also begun to trim their assumed rates to reflect either lower inflation or a less optimistic outlook for real returns, triggering calls for increased contributions from state and local government sponsors.
On the negative side, lower assumed returns mean that pensioners must look to some combination of increased saving, reduced benefits and older retirement ages.
On the beneficial side, they force investors and plan sponsors to recognize shortfalls that would have come sooner or later anyway, and may promote a more balanced and sensible approach to risk-taking.
For the sake of simplicity, the FSA historically assumed portfolios on retail products were split 67:33 between equities and bond investments. In practice, pension fund portfolios average around 60 percent equities, according to the PwC study, and insurance products commonly invest 50 to 100 percent in bonds.
In its study for the FSA, PwC examined expected returns on a benchmark portfolio with 57 percent in equities, 23 percent in government bonds, 10 percent in corporate bonds and 10 percent in property to show the potential impact of a shift towards fixed income investments and away from equities.
In reality, pension funds have adopted a range of strategies to meet their assumed rates of return in tough market conditions. For example, the South Carolina Retirement Systems has put 50 percent of its assets into high-risk, high-return alternatives such as private equity, while the Texas Municipal Retirement System is 62 percent invested in fixed income, according to NASRA.
There is some evidence that pension plans have boosted their risk exposure as they chase high assumed rates of return in difficult markets. Rather than settling for lower pensions and returns, managers have felt obliged to take more and more risk in order to generate an acceptable return on behalf of their members, often underestimating the potential for downside volatility and shortfalls in the process.
If that has indeed been the case, then cuts in projected rates could promote strategies that take less risk and reduce demand for some of the higher-risk products that investment banks have been marketing aggressively over the past decade.
Lower projected rates of return could highlight the need for greater saving for retirement over the long term and more realism about retirement ages and incomes. In the short term, they should unlock a broader range of capital projects as institutions and firms learn to accept more modest payoffs.
If lower FSA projection rates indicate the start of a broader reassessment, it could help promote healthy rebalancing by reducing excessive risk-taking by the financial sector while encouraging more physical investment by firms on the real side.
(John Kemp is a Reuters market analyst. The views expressed are his own)
editing by Jane Baird