Return projections should not focus on past

By DAVID MOON, Moon Capital Management, LLC
July 29, 2012

Last week’s column about pension and healthcare costs drew comments from readers about the investment return assumptions pension plans use when calculating pension costs. The Knoxville City Pension Board recently adopted a 7.375 percent assumed rate of return.

One reader accurately noted that the actual return on the City pension assets over the past five years was only little more than three percent a year. “If their investments are earning three percent then that’s the rate they ought to use.”

It’s that sort of back-looking thinking that contributed to the current retirement and investment problems across the country, not just in municipal pension plans. (Knoxville’s pension investments earned 7.67 percent annually over the past 15 years, by the way.)

The past does not equal the future. It is very easy to take five or ten year’s worth of data and extrapolate 10 or 40 years into the future, but there is no logical reason for making projections that way. Projections should depend on conditions at the time they are made – and the conditions today are completely different than they were 10 or 20 years ago.

In late 1999, who would have projected a one percent annual loss for the Dow Jones Industrial Average over the next decade? The Dow had just increased from 1,000 to 12,000.

Fast forward to today. What is a reasonable return assumption for the next 10 or 15 years? A simpleton would look back and suggest a negative one percent future growth rate for stocks.

That might be right, but I doubt it.

For many investors, retirement plan investment choices fall into some broad basic categories: cash, bonds and stocks. The yield on a ten-year Treasury bond is currently 1.4 percent. Ten-year investment-grade corporate bonds yield about 2.8 percent. Fixed income returns are likely to fall between those levels, at best.

Money market funds pay practically nothing today. Assume that will change, but not much.

The long-term average annual return of the S&P 500 is 10.5 percent. The average P/E ratio on the S&P 500 is 15 times earnings, about where it is now. In January 2000 the P/E on the S&P 500 was a staggering 28 times earnings. Stocks had to return significantly lower than the 10.5 percent long-term average in order to adjust for the higher P/E.

The current P/E of 15 doesn’t guarantee that stocks will return the historic average of 10.5 percent over the next ten years, but it increases that likelihood significantly – especially compared to a starting point at which the market was selling at a P/E almost twice the historic average.

In 2000, anyone who assumed that the next 12 years were going to look like the previous 12 years was almost guaranteed to look pretty silly.

The loudest voices today are the ones who project that the next 10 or 12 years are going to look something like the previous 10 or 12. I suspect their projections will eventually look similarly silly.

Our expectation about the future should depend on where we are, not where we’ve been.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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