Ah models, my old friends. You’re always wrong, but sometimes helpful. Often dangerous too.
A recent article in The Actuary magazine addressed whether “de-risking in members’ best interests?” I say “recent” even though it’s from August because I am a little behind on my The Actuary reading.
In the article, the authors demonstrate that by modelling the impact of covenant risk, optimal investment portfolios for Defined Benefit (DB) pensions actually have more risky assets than if this covenant risk is ignored.
The covenant they refer to is the obligation of the sponsor to make good deficits within the pension fund. Covenant risk then is the risk that the sponsor is unable (typically through its own insolvency) to make good on this promise.
On the surface it should seem counterintuitive that by modelling an additional risk to pensioners, the answer is to invest in riskier assets, thus increasing risk.
The explanation proffered by the authors is that the higher expected returns from riskier assets allow the fund to potentially build up surplus, thus reducing the risks of covenant failure.
It’s worth reading in its entirety for the insights. I don’t agree with everything there, and I certainly don’t agree with the widely held view (not among the authors) that the universe of countries included in the survey is supposed to be somehow representative of the world.
The countries chosen have an absolutely clear bias in their selection. They are successful economies with successful financial markets. They are included by virtue of their long-term success and capital growth and returns for investors.
The authors know this, but many readers don’t. The returns per this survey are an overly rosy view of possible future returns.
This work provides a fairly in-depth analysis of the differences between the various definitions of ERP and a comprehensive survey of major sources for estimates of these. In general, the estimates of the Expected ERP over T-bonds (rather than short-dated T-bills) are in line with the range I use of 3% to 5% with several showing values to the lower end of this range.
The debate certainly isn’t over, but these papers and the referenced papers, research and textbooks are a good starting place to get up to speed.
I recently had a conversation with a colleague who had been told that “Credit Suisse recommended an Equity Risk Premium of 7%”. I’m curious to know whether they truly view that as an appropriate ERP. If your ERP is 7%, it’s still too high.
The updated research shows a very familiar picture to that of the book. Here are a few important outcomes:
Realised excess returns of equities over bonds have been negative for most countries for the last decade.
Clearly, using realised excess returns (or historical ERPs) over a short period as a measure of future ERP is a bad idea. I’m fairly sure the future ERP is positive.
For the World, the US, the UK, Australia, Belgium, Canada, Denmark, France, Germany, Ireland and South Africa (a few countries I chose to look at before I realised the trend is near-universal) have had declining historical ERPs over the last 110 years. Some have had a few bumps in between, but the overwhelming trend has been downward. The last decade’s poor performance has obviously helped establish this trend, but it was pretty well established for most of these countries even without the last decade.
Using unadjusted historical ERPs over long periods is a dangerous idea because trends in the data make it a poor estimate of future experience.
Junk Bonds are debt instruments issued by corporates that have relatively low credit ratings. They pay interest at high rates as a result.
Typically viewed as risky investments, the junk bonds boom of the 80s showed that there is more to junk than just a risky investment.
Locally, our pension funds and other retirement savings money should be more heavily invested in junk bonds. I’m surprised more people aren’t talking about this. It might be due to the limited availability of junk in the SA market. On the other hand, if demand picked up, I’m sure we could see more original-issue junk bonds as yields drop and become more attractive financing vehicles.
There are always marks for considering tax
Why should pension funds be invested in junk? Tax. Approved retirement savings vehicles in South Africa don’t pay income tax. Thus, the value of securities that would attract significant tax is higher for these investors than for the market as a whole. If risk and return are balanced for the market as a whole, the extra return available to retirement vehicles through not paying tax is a bonus over and above that appropriate for the risk.
I have a clear strategy for how not to lose money playing the Make a Million competition. As I explain it, you may come up with some smart tactics to win the competition and enhance your returns, but you’re on you’re own there.
So, how does one not lose money with the Make a Million competition?
You are overwhelmingly like to lose money if you enter this competition. I’ve said this before, and I’ve been right before. I’m right again.
When companies value pension obligations and required contribution rates, they make assumptions about the expected future investment returns. (Accounting standards require market-based rates reflecting fixed interest returns, but that’s a separate point).
FinanceClippings assumes a simple portfolio mix of 50% equities and 50% government bonds in this calculation, and assumes the average yield will be consistent with 30-year assumptions. I would differ slightly here. If we are looking at an overall portfolio, I would expect some investment grade corporate bonds and property in the mix too. These assets could be expected to earn 1% to 2% over risk-free over time (after adjusting for expected default loss on the corporate bonds). These return assumptions may seem low to some, but this is another area where it’s easy to overestimate the possible returns based on inappropriate periods of data. Continue reading “Implied Pension Return Assumptions and the Equity Risk Premium”