I recall co-authoring a report in 1982 in which we predicted that future inflation would be 9% a year for the long term. That sounds crazy now, but it seemed reasonable at the time, especially considering that inflation averaged 9.7% a year over the previous 10 years, with no end in sight.
This was a useful personal reminder of something every actuary inherently knows: whatever assumption we make about the future, we will get it wrong—sometimes spectacularly wrong—because the number of possibilities are endless and the future is inherently unknowable.
The average inflation rate from 1923 to 1981 was just 3.0%, which, as it turned out, proved to be a much more accurate forecast of future inflation than the experience from 1973 to 1982. Why, then, did we use 9% in that study? It wasn’t because historical data didn’t exist. Rather, we had convinced ourselves that the future would look a lot more like the recent past, and we had cogent, sophisticated reasons not to expect a reversion to the norm. In other words, we subscribed to the belief that this time (i.e., in 1982) it was truly different.
We might be in the midst of repeating this error in judgment. For several years now, actuaries have been using a building-block approach to determining long-term returns on pension portfolios. They start with an estimate of inflation and then add to it the real returns expected from each class and subclass of investments, appropriately weighted by the long-term asset mix of the pension plan in question. The result is further adjusted for the effects of periodic rebalancing, fees and provision for adverse experience.
This rather scientific process has led us to lower our estimates of future investment returns. Most actuaries now believe nominal returns for the typical pension fund will average out to between 5% and 6% a year, a far cry from the 8.5% average return that the median pension fund actually achieved over the past half century.
While the 5% to 6% range may ultimately prove to be accurate, there is room for at least a little skepticism. With the worst financial crisis still fresh in our minds, it would not be surprising if we subconsciously embedded a little pessimism into our forecasts. In August 1979, BusinessWeek (now Bloomberg Businessweek) published a cover story entitled “The Death of Equities,” which made a compelling case why equities would not do as well in the future as they had in the past. It cited a 10-year rise in gold prices, individual investors leaving the stock market in droves after suffering big losses a few years earlier, people putting their faith in housing as their major investment rather than stocks, and institutions looking hard at alternative investments in order to reap better real returns. Sound familiar? By the way, the return on supposedly dead U.S. equities averaged 17.9% over the 20-year period measured from 1979.
We don’t need to go back so far to find examples in which conventional wisdom seems totally sound but proves to be off the mark. Only several months ago, most of us were confident that long-term interest rates would stay low for many years to come. Since then, the mere hint of tapering (of the Federal Reserve bond-buying program) in the U.S. has been enough to raise nominal yields on U.S. Treasuries by more than 100 basis points and on Government of Canada long bonds by nearly as much.
So where does that leave us? In 25 years’ time, we may look back and marvel that the actuaries of 2013 were so prescient in predicting much lower returns on pension assets than we had historically enjoyed. My guess, though, is that we will concede we got caught up too much in the zeitgeist of a gloomy economic era; future investment performance may well turn out to be brighter than we think.