Estimating returns tricky, even for the pros

Estimating future returns in the stock and bond markets involves plenty of guesswork. Even investment professionals grapple with that dilemma, as recent pension-fund deliberations show.

CalPERS, the giant pension plan for California public-sector workers, generated headlines when it recently decided to reduce its estimate of future returns very gradually to 6.5 percent from 7.5 percent. The trend toward reduced expectations already had been underway at various other pension funds in New York, Illinois, Arizona and other states. The moves recognize lofty stock-market valuations, decades-low bond yields and other factors that can make it hard to realize future goals.

For pension funds, one consequence is that municipalities or other entities that pay into these funds, along with their employees, often will need to boost their ongoing contributions to make up for subdued investment results. But the more interesting and broader implication is that investors everywhere — not just pension-fund managers and beneficiaries — might need to prepare for lower returns by saving more money, taking on greater risks — or both.

Pension funds can be good guides for what types of returns mainstream in-

vestors can expect. The funds have long investment horizons, meaning they often pump up portfolios with stocks, real estate and other growth assets. But they also have ongoing payout obligations to retirees and other beneficiaries, forcing them to maintain some liquidity. Thus, pension funds maintain a balanced portfolio divided among growth investments and fixedincome instruments. Most people also invest with balance in mind.

Actually, the challenges highlighted in the recent CalPERS decision have been apparent for a while. Pension funds have been forced to “reach for yield” and accept greater levels of risk to meet their goals, Moody’s Investors Service said in a recent report.

“U.S. public pension funds have maintained investment-return assumptions above 7 percent by shifting away from fixed income toward more volatile assets (such as stocks),” the report said.

For example, CalPERS in 1990 held 50 percent of its assets in bonds and cash, but that’s down to 20 percent today. “Meanwhile, (the fund’s) investments in riskier assets such as real estate and equities have conversely risen,” Moody’s said.

The report cited an even more extreme example: The South Carolina Retirement System was solely invested in fixed-income securities until a 1997 state constitutional amendment allowed it to add U.S. stocks, according to Moody’s. Now, the fund has only about 12 percent of its portfolio in cash and bonds and most of the rest in stocks and other potentially volatile investments.

J.P. Morgan reduced its long-term expectations for most types of investments over the next decade. Of 51 asset classes tracked, only five have expected annual compounded returns of 7.5 percent or higher — and these tend to be in volatile, somewhat esoteric areas such as private-equity companies and the stock markets of developing nations.

For mainstream investors, there are some lessons to be learned from the tough choices faced by pension funds.

» Stock prices still might have room to run on the upside — perhaps more than a lot of people assume. But investors nevertheless are taking on more risk for each 1,000-point domino that the Dow Jones Industrial Average knocks over on the upside. Pension funds, and other balanced investors, typically don’t abandon their stock holdings entirely, even when prices are high. This reflects the market’s longterm propensity to rise, albeit in fits and starts, and the potential to stay at elevated levels for years.

» Low yields on bonds present an even more formidable challenge for entities such as pension funds and retirees managing their own portfolios. There’s a lot less wiggle room for mistakes when bonds are yielding around 2 percent, as they are now, for 10-year Treasurys, compared to the 5 percent payouts of a decade ago and 7 percent 20 years ago.

» Subdued investment results, when they occur, often must be made up somehow. For pension funds, this usually involves asking employers and workers to ante up more cash. For private investors, it can mean adding more money from each paycheck into 401(k)-style retirement plans or other other vehicles.

» Underscoring these portfolio changes is the assumption that returns for various assets will “regress to the mean” or fall back in line with their long-term averages. For stocks, this doesn’t necessarily mean that the supercharged gains of the past several years will be followed by a crash. But at a minimum, a cooling-off period of mild losses or single-digit gains, possibly spanning several years, is likely. In other words, things even out over time.

If there’s one consoling thought, it’s that these decisions aren’t easy, even for professionals. Everyone with investment dollars at stake is in the same boat, pondering what to do if future returns don’t exactly sizzle.