By: Russ Kamp, Managing Director, Ryan ALM, Inc.
Forecasting future market returns is fraught with peril! To Horizon Actuarial’s credit, they understand how challenging it is to forecast tomorrow’s market activity let alone 10-year, 20-year, and 30-year returns, risks, and correlations. Since 2010, they have acquired forecasts from leading consultants, actuaries, and investment managers, and since 2012, they’ve published those results. Let’s give a big thank you to Horizon and to the organizations that provide the inputs to this analysis. I find this survey to be helpful.
The 2022 forecast was published in August and mostly reflects the common wisdom that existed at the end of 2021. It would be quite interesting to see how those forecasts would change if they had a mulligan. I suspect that future returns from today forward would look better, especially for bonds. The fixed income returns in this analysis reflect an interest rate environment that had yet to break out from a nearly four-decade slide toward zero yields. The Treasury forecast, described as cash equivalents, predicted a 1.56% annualized return for the next 10 years. The 1-year T-Bill is yielding 4.16% today. The 3-year Note’s yield is 4.4%. Since corporate bonds trade off the Treasury yield curve and provide a healthy spread in yield, the investment grade corporate bond equivalent will be providing a very attractive yield in the 5%+ range.
As interest rates continue an upward trajectory, bond cash flows will become more robust providing greater coverage of liability cashflows (benefits and expenses). The higher the yield the smaller the present value $s needed to meet those future value promises. Bifurcate your asset allocation and create a liquidity bucket within your pension plan that takes advantage of these expanding yields. At the same time, transform your remaining exposure into a growth (alpha) portfolio that will now benefit from the “buying of time” from the liquidity bucket (e.g. 1-7 years). Horizon’s survey highlights expectations for a number of less liquid alternatives, including private equity (9.2%), real estate (5.4%), Infrastructure (6.4%), and private debt (6.9%) that will benefit from this asset allocation configuration. The survey also has an expectation for hedge funds at 4.8% annually for the next 10 years. However, given that short Treasuries are now yielding nearly that return why bother with those cumbersome and expensive offerings?
The last decades have been an unbelievable time for the capital markets and many pension systems. Regrettably, the days of Fed accommodation and low rates are gone. In their wake, we must adopt an approach that will help fund benefits while generating growth to meet tomorrow’s liabilities. Sitting back and doing nothing is not acting with fiduciary prudence. Adopting a bifurcated asset allocation is simple. Migrate your current return-seeking fixed income from an Aggregate-type portfolio to one focused on matching asset cash flows with liability cash flows. Then sit back and watch the magic unfold.