By: Russ Kamp, Managing Director, Ryan ALM, Inc.

This blog is a follow up to a post that I published last week. In that post I cited a recent analysis by Goldman Sach’s forecasting a 3% 10-year return. I concluded the blog with the following: “I wouldn’t worry about the 5% fixed income yield-to-worst (YTW) securing my pension liabilities. Instead, I’d worry about all the “growth” assets not used to secure the promises, as they will likely be struggling to even match the YTW on a CFM corporate bond portfolio.”

How likely is it that Goldman and other financial institutions are “right” in forecasting such a meager return for the next decade? I’m sure that plan sponsors and their advisors are pondering the same question. Well, here is more insight into how one forecasts long-term equity returns (not necessarily Goldman’s forecasting technique) and how one might arrive at such a low equity return (S&P 500 as the proxy) that, if realized, would likely crush pension funding.

Inputs necessary to forecast the future return for the S&P 500 are the current S&P EPS ($255), future expected EPS growth (5.5%) and an assumed P/E multiple in 10 years. Finally, add in the dividend yield (1.3%) and you have your expected annualized return.

Charles DuBois, my former Invesco research colleague, provided me with his thoughts on the following inputs. He believes that nominal earnings growth will be roughly 5.5% during the next decade, reflecting 4% nominal GDP growth coupled with a small boost from increasing federal deficits as a share of GDP and a boost for net share buybacks (1.5% in total). 

Right now, earnings per share for the S&P 500 are forecasted to be about $255 in 2024. If earnings grow by the 5.5%/per annum described above, in 10 years earnings for the S&P 500 will be $428 per share.

The S&P is currently trading at 5,834, which is 22.9X (high by any measure) the current EPS. Let’s assume a more normal, but still historically high, multiple of 18X in 10 years. That gets you to an S&P 500 level of 7,704 or a 2.8% annual rate of gain over the next 10 years.  Add in a 1.3% dividend yield gets you to 4.1%. Not Goldman’s 3%, but close. It is still much lower than the long-term average for the market or the average ROA for most public and multiemployer pension plans.

If one were to assume a 15X P/E multiple in 10 years, the return to the S&P 500 is 0.64%/annum and the “total” return is slightly less than 2.0%. UGLY! Obviously, the end of the 10-year period multiple is the key to the return calculation. But all in all, the low returns that most investment firms (including Goldman) are forecasting seem to be in the right neighborhood given these expectations.

Given the potential challenges for Pension America to achieve the desired return (ROA objective) outcome, a cash flow matching (CFM) strategy will help a pension plan bridge this potentially difficult period. Importantly, by having the necessary liquidity to meet monthly benefits and expenses, assets won’t have to be sold to meet those obligations thus eliminating the potential to lock in losses. Lastly, the roughly 5% yield-to-worse (YTW) on the CFM portfolio looks to be superior to future equity returns – a win/win!

It just might be time to rethink your plan’s asset allocation. Don’t place all of your assets into one return bucket. Explore the many benefits of dividing pension assets into liquidity and growth buckets. Want more info? Ryan ALM, Inc. has a ton of research on this idea. Please go to RyanALM.com/research.