Tuesday, June 13, 2006

Forecast Investment Returns

It is always valuable to document and evaluate the investment return assumptions used to create the actuarial assumed returns for a defined benefit plan or the investment eranings asumptions used to generate participant financial plans in a 401(K). Mellon has published their 5 year return forecast. Mellon's 5 year forecast expectations are inflation 2.25%, Large cap US equity 8.5%, Small Cap Equity 9%, International Equity 9% & Intermediate bonds 5.45%.

Using these assumptions a 60% equity portfolio with 20% of equity in International and 20% of domestic equity in small cap and 40% Intermediate Bonds would have a forecast return of about 7.4%. The industry mean actuarial assumed return is about 8%....leaving us with .6% gap. Typically actuaries will use a longer term inflation rate of 3%-3.25%, more consistent with the intermediate assumption used in something like Social Security forecasts. This difference in expected inflation is often the primary reason why your actuarial returns may be higher than a calculated returns using 3-5 year forecast numbers like these. Differences in portfolio asset allocation can also impact forecast returns..higher equity/higher returns.

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