Thursday, February 10, 2005

Market Experts have Low Expectations

Reuters reported from Geneva today that "US corporate pension funds, already struggling with a multi-billion dollar industry deficit have unrealistic expectations for investment returns that are likely to be well below their forecasts in 2005 leading market experts said". While I read this quite often these days and admit the logic for this position is credible, I can't say I am fully convinced.

Forecast investment returns for pension plans should correlate to the time horizon of plan liabilities. For many plans this planning horizon would be 25 plus years. When I think about capital market characteristics over that horizon I think it is shortsighted to extrapolate based on todays P/E ratio or dividend yields. There is a lot of uncertainty to overcome in a 25 year projection so simple historical statistics like a long term historical 6%-7% real return on equity seem as valid and probable as what the market experts are forecasting based on todays market conditions. On the other hand, if I were the CIO of a pension plan it would be to my advantage to "talk down" expectations for future returns. That strategy has the dual benefit of being credible and minimizes professional downside risk. Any rational person operating under a performance incentive system relative to a benchmark should be pessimistic when positioning the benchmark. We have been hearing about the "low return environment" since 2002 and have since had 2 very good market years. If this is low....give us more!!

I also am puzzled by a statement in the article which says that "US corporate pension funds have penciled in average expected returns of 9.1% in 2005, meaning many see their investments performing well above this level." Remember, corporate pension plans are generally audited. Other than my former ArthurAnderson friends, auditors I know like to see reasonable substantiation of expected returns and they get very nervous when they are asked to sign off on expected returns north of 9%. Anecdotally, I haven't seen a plan forecast return above 9% in a while though I am sure some still exist. Very hard for me to believe that 1/2 the US corporate pensions use expected returns "well above this level".

While it is interesting and thought provoking to see what the experts think..the one thing we can count on is watching the markets confound them as well.


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