In recent years, many public and corporate pension plans have lowered their official Expected Return on Assets (EROA). 1 1 Close Source: Public Plans Data (PPD). 2001-2018. Center for Retirement Research at Boston College, Center for State and Local Government Excellence, and National Association of State Retirement Administrators. One might think it would now be easier to hit those hoped-for returns, but if anything, it has become even harder.
The EROA is a goal that is only weakly influenced by real life investing conditions. In contrast, the portfolio’s actual expected return is very much of this world, and the world has changed. It’s not that we are “late cycle,” or that valuations are high (though that may be and may matter); it’s that the yield on cash 2 2 Close Source: Bloomberg. Yield on cash based on 3-month U.S. Treasury Bills. has fallen — a lot — and as a consequence, expected total returns have fallen, too.
So while pension boards have modestly dropped their discount rates in response to what they perceived to be a low return environment, return expectations have dropped a lot more. The seemingly softer EROA target has really become a much tougher one.
Don’t Confuse EROA with “Expected Return”
The EROA is important to determine plan liability values and required contributions. It has a lot of real-world impact, so it matters, but this “Expected Return” is not the expected return. The EROA is commonly set by policymakers or boards, taking into account political considerations, funding capabilities and, sometimes, corporate finance considerations. The true “expected return” on assets is the weighted average of the individual expected returns of each asset class in the portfolio. Once an asset allocation is determined, its expected return is not subject to political diktat, budget realities, or accounting needs.
The following analysis focuses on public plans, but the challenges are similar for corporate plans.
If we go back to 2001, a much simpler time for plan sponsors, the average U.S. public pension discount rate (EROA) was 8.0%. 3 3 Close Source: Please see footnote 1. But in our estimation, their asset allocation-based “expected” return was 8.4%. 4 4 Close Source: AQR, Public Plans Data (PPD). 2001-2018. Center for Retirement Research at Boston College, Center for State and Local Government Excellence, and National Association of State Retirement Administrators. Portfolio based expected total returns based on the asset weighted asset allocation public plans and capital market assumptions described in the disclosures. For illustrative purposes only. Hypothetical data has inherent limitations some of which are described in the disclosures. There is no guarantee that these expected returns will be achieved. Today, on the other hand, EROA across 190 U.S. public plans averages 7.3%. 5 5 Close Source: Please see footnote 1. But we estimate the “expected” return of those portfolios to be only 5.3%. 6 6 Close Source: Please see footnote 4.
It is certainly harder to achieve a 7.3% return with a 5.3% allocation than it is to achieve an 8.0% return with an 8.4% allocation. But it gets even harder when you consider that fund managers are already working those assets more aggressively.
What Really Matters Is the Excess Return over Cash
Central bank changes to the cash rate might induce asset prices to go up or down, but there’s little evidence or theory that the mere level of the cash rate affects assets’ return premium over it.
Unless we have strong market timing views, we have little reason to believe that the excess return over cash should be any different when the expected risk-free return is 5.0% (2001) than when it is 1.5% (today). 7 7 Close Source: AQR, Bloomberg. Estimate for expected cash return is based on average 1-year U.S. Treasury rates zero to nine years forward on January 1, 2001 and August 20, 2019. If you held your asset allocation steady, you should expect to earn about 3.5% less today (the difference between 5.0% and 1.5%) than you did nearly 20 years ago. That is, the fact that we expect to be in a low rate environment for the foreseeable future is enough to explain why we expect to be in a lower portfolio return environment.
Now it’s true that asset allocation has evolved over the last twenty years. Pension funds have made changes that produce a higher expected return over cash today than in 2001, but that is not enough. Funds have increased their risk, helping to add about 0.4% to expected return (in our estimation), and increasing their expected return over cash from 3.4% to 3.8%. 8 8 Close Source: Please see footnote 4. So, including the expected cash return, total return expectations have gone from 8.4% down to 5.3%. With EROA falling only 0.7% over that same time, we’ve gone from expecting to beat the target to expecting to fall well short (See Figure 2.)
In short: in 2001 pensions needed 3.0% over cash to reach their EROA; but today they need 5.8%. Pretty clear which one is harder.
Recent Equity Returns Have Masked This Challenge
The drop in EROA and cash returns has occurred while, in real life, recent realized excess returns over cash for equities have been very high. That has largely hidden the real detrimental impact of lower cash rates on expected total returns.
There is little reason to expect that the equity return premium over cash should stay so spectacularly high just because cash returns are low (Figure 3.) Compared to a nearly fifty-year average equity risk premium over cash of 4.5%, the last five years have given us more than double that, with an average risk premium of 9.4%. 9 9 Close Source: AQR, Bloomberg. S&P 500 Index and ICE BofA Merrill Lynch 3-Month U.S. Treasury Bill Index returns from January 1970 to August 2019.
If equity excess returns come “back to normal” in an environment in which cash remains this low, then the challenge facing CIOs and staffs will be far more apparent than it has been in recent years.
Life for plan sponsors isn’t easy. Twenty years ago the chances that public pensions would hit their long-term target were over 50%. 10 10 Close Source: Please see footnote 4. Today, we think those changes are closer to 30%. 11 11 Close Source: Please see footnote 4. That’s with lower EROAs and portfolios designed to earn higher excess returns. The culprit is cash, which can’t be controlled (at least not by investors!) That’s not to say that nothing can be done — boards could continue to reduce Expected Returns and CIOs could continue to improve their portfolios around the margins. They’ll have to if they expect to meet their expectations.
Charles E.F. Millard is a consultant to AQR Capital Management, LLC.
Asset weighted asset allocation for U.S. public plans sourced from Public Plans Database (PPD). To estimate volatilities, we use a rounded (to the nearest full number, except for cash, which is rounded to the nearest decimal) average of the realized since 1990 and since 2008 volatilities of the following indices: For Equities, we use MSCI World Index. For Private Equity, we use 1.2x Levered Russell 2000 Index. For Real Estate, we use the FTSE/EPRA NAREIT All REITs Index. For Commodities, we use the Bloomberg Commodity Index. For Fixed Income, we use the Barclays U.S. Aggregate. For Hedge Funds, we use the HFRI Fund Weighted Composite Index. For Cash, we use the ICE BofA BofAML US 3 Month Treasury Bill Index.
We assume a constant long-term Sharpe Ratio of 0.3 across asset classes to calculate excess returns.
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