US equity indices have hit record highs in recent months after a breakneck rally from the deep coronavirus sell-off earlier in the year. But even at these stretched valuations, pension investors need to buy more stocks and other riskier assets.
That might seem like a counter-intuitive, or even reckless, line of argument. How can it be right to urge pension funds, and individual savers, to take on more risk at this point? The S&P 500 blue-chip index has a forward price/earnings multiple — a common measure of value — well above 20, according to our forecasts, compared with an average of 17 times during the past two decades.
Bluntly, because they do not have a choice.
Many institutional pension funds and individuals do not save enough now to meet their future cash flow needs. It is accepted that a certain level of risk is needed in order to grow the inflation-adjusted value of retirement assets. It is assumed that investing in capital markets will preserve, at the very least, the purchasing power of those assets.
I believe that, post-coronavirus, the level of risk carried by pension plans has to materially increase. This raises questions for policy and regulation, as well as what investment framework institutional pension funds and individual savers should use. The underlying challenge is that the anchoring of interest rates at low levels has shifted the balance of power from savers to creditors. What does it even mean to make long-run saving decisions in a world of negative real yields?
There are two key factors to consider. First, the trade-off between return and risk across traditional asset classes seems set to deteriorate. This balance has been exceptionally good for 40 years, during which a simple 60/40 portfolio of US equities and 10-year bonds has delivered a 7 per cent annualised inflation-adjusted return. But high asset valuations across equity and bonds, and the prospect of increasing inflation, make it harder to see how this will continue.
Second, while high equity valuations do not imply that the market will necessarily fall, it does mean volatility is likely to remain elevated. The correlation of stocks and bonds has been firmly negative in the recent past, allowing for easy diversification, but there are reasons to believe this will come to an end. As equities and bonds become more correlated, overall portfolio risk increases. It will thus be likely that pension fund performance will be more volatile in the future. Investors need to respond to that.
There are things they can do. Their goals must be clearly defined, such as a “real” return target that takes inflation into account. Most high-grade government and some corporate bonds are at risk of delivering negative real returns. Since investors are being asked to take on more duration risk, and are being offered a less effective equity hedge, it is likely that the future allocation to such bonds will fall materially.
If we accept that the policy response to coronavirus is likely to be inflationary, an environment that erodes the value of fixed income, it implies that a large equity allocation is needed at the heart of a retirement portfolio.
But this alone will not deliver a good enough return, or sufficient diversification, hence a need for alternative investments, such as long/short equity strategies and private assets such as infrastructure.
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The investment framework needs to be considered, too. This requires so-called factors — such as income (the long-term performance of dividend-paying stocks) and momentum (the idea that stocks that have done well will continue to prosper) — to be used alongside traditional bets to provide enough sources of return and a spread of risks.
Finally, it would be helpful if pension funds were able to articulate risk in terms of the probability of missing long-term pension promises. The real risk is the possibility of hardship for beneficiaries.
The unprecedented fiscal and monetary interventions in the coronavirus crisis show that we have entered a new policy regime. However, the policy equation should also include the need for investment assets that can realistically preserve purchasing power over the long term.
If real rates have to be anchored at low or negative levels, that may require a policy shift to allow increased risk for pension funds. Saving for retirement is about to become more challenging. It is better to face up to the new reality than ignore it.
The writer is head of portfolio strategy at asset manager Bernstein
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