America’s pension system is already facing many challenges whether we are discussing private, public, and/or multiemployer plans. The issues may vary depending on the type of plan, but the one thing that they have in common is their participation in our capital markets. For many (most) plans, they continue to believe that a 7.00%+ return on asset assumption (ROA) is doable. Well, I’m sorry to be the Grinch in this story, but given current equity valuations, it is unlikely that returns from domestic equities will help them achieve their return objective. As the chart below highlights, we are currently (dotted line) at a very inflated valuation for equities, as measured by the Cyclically Adjusted Price/Earnings Ratio (CAPE).
CAPE, also referred to as the Shiller P/E, is a valuation measure usually applied to the S&P 500 equity market. It is defined as price divided by the average of ten years of earnings (moving average), adjusted for inflation. There have been only three previous examples when the CAPE was higher than it presently is today (P/E = 34X). In each of those cases, the S&P 500 produced a 10-year real return that was negative (2001, 1999, and 2000). Now, market observers would tell you that given the low interest rate environment valuations can be stretched beyond where they have historically have been, which is a fair comment. But, this chart highlights real returns that are adjusting for inflation. The long-term real return for stocks has been 6.8%. In no case for those periods of high valuation has the subsequent 10-year real return eclipsed the long-term average for the equity market.
Given the impact that Covid-19 is having on the ability of plan sponsors to increase contributions, a lower return environment will further challenge these plans trying to maintain or improve funded status. What should plan sponsors do? Well, it will be important for them to “buy time” so that they can navigate the next 10-years that might prove challenging. They should look to improve the plan’s liquidity profile by cash flow matching (CDI) the Retired Lives Liability for the next 10-years utilizing their fixed income exposure. This strategy will then allow the alpha assets to grow unencumbered. Importantly, by creating alpha and beta buckets, plan sponsors will no longer be forced to sell alpha assets at inappropriate times for funding purposes.