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Equity Risk Premium
Old 03-19-2012, 06:03 PM   #1
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Equity Risk Premium

Equity markets: Shares and shibboleths | The Economist

An interesting article from the latest Economist discussing the proper equity risk premium to assume in retirement planning, and why it is lower than you might think. The conclusion of the article:

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Equities are not a miracle asset that will turn measly contributions into a generous pension. Those who want to retire in comfort should save more.
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Old 03-19-2012, 06:42 PM   #2
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Pretty grim conclusions regarding pension funds.
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Pension providers have two options: increase contributions or cut benefits. Cutting benefits will be difficult for many American states since pension rights are legally or constitutionally guaranteed. So taxes will have to go up or other services will have to be cut.
But then, increases in contributions and cut in benefits are both occurring, for those (ever fewer) pensions that still exist. Still, the article explains reasons for this quite nicely.
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Old 03-19-2012, 08:40 PM   #3
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Pretty grim conclusions regarding pension funds.

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Pension providers have two options: increase contributions or cut benefits. Cutting benefits will be difficult for many American states since pension rights are legally or constitutionally guaranteed. So taxes will have to go up or other services will have to be cut.
But then, increases in contributions and cut in benefits are both occurring, for those (ever fewer) pensions that still exist. Still, the article explains reasons for this quite nicely.
Cuts in benefits already earned are pretty rare for state pensions, I think. There are cuts happening for future earnings.

I hear the statement that IL state pension benefits are Constitutionally guaranteed. But Constitutions can be changed by amendment. I wouldn't rule this possibility out, though it may be slim. If enough taxpayers are asked to pay enough of an increase, the majority just may speak.

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Old 03-20-2012, 07:02 AM   #4
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What I can never wrap my head around with these grim forecasts about future market returns is the real impact on SWR. If the ERP is lower going forward does that imply that with the volatility of various market shocks we should expect some periods that are significantly worse than the worst of the historical record? Or does it simply imply that we are more likely to be on one of the lower earning scenarios in the historical record? Looking at the projections (nominal 6% returns) I would be reassured that with a 3-3.5% SWR I would be pretty safe. On the other hand, if that lower nominal return equates to a number of new 30 year periods on the horizon that fall substantially below any we have seen in the last 100 years, then all bets are off. Wait and see I guess?
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Old 03-20-2012, 07:12 AM   #5
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Peter Bernstein said this 7 years ago
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Equities are still valued at historically high prices. Interest rates, I don't have to tell you, are historically low. And so you start from there, and there you are. I think something very important to think about this, that a period of low returns, you think, well, every year maybe we'll have 4%, 5%. It doesn't work that way. Low returns result from high volatility. You have a big year, and then a bad year, and the pattern of low return periods is high volatility, not low volatility. It's a scary time.
Volatility is a killer of retirement portfolios. Looking at the thread about the '08 financial crisis (The financial crisis of 2008, uncertainty, and change in plans ) shows how difficult it is to navigate the markets and how easy it is to end up on the losing side.
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Old 03-20-2012, 07:25 AM   #6
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I think the point in this article that hit me the most is
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One obvious problem with their reasoning was that, although equities might have beaten bonds over most long periods, the horizon of the average investor is much shorter.
I know this in principal but I'm left with thinking what would happen if we hit the Japan model for the next 20 years? How would I know equities are in trouble, and how would I respond with my AA to this. Just thinking, trying to war game and plan for this should it happen. Any ideas how to plan for something like this where equities don't do anything for the next 20 years?
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Old 03-20-2012, 10:56 AM   #7
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I think the point in this article that hit me the most is

I know this in principal but I'm left with thinking what would happen if we hit the Japan model for the next 20 years? How would I know equities are in trouble, and how would I respond with my AA to this. Just thinking, trying to war game and plan for this should it happen. Any ideas how to plan for something like this where equities don't do anything for the next 20 years?
I heavily diversify my AA internationally. If the U.S. economy looked as stagnant as Japan's has, then I'd worry about U.S. stocks a bit more. Economies are a little easier to predict than markets, I think. But 20 years into the future, who knows.
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Old 03-20-2012, 11:08 AM   #8
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Originally Posted by donheff View Post
What I can never wrap my head around with these grim forecasts about future market returns is the real impact on SWR. If the ERP is lower going forward does that imply that with the volatility of various market shocks we should expect some periods that are significantly worse than the worst of the historical record? Or does it simply imply that we are more likely to be on one of the lower earning scenarios in the historical record? Looking at the projections (nominal 6% returns) I would be reassured that with a 3-3.5% SWR I would be pretty safe. On the other hand, if that lower nominal return equates to a number of new 30 year periods on the horizon that fall substantially below any we have seen in the last 100 years, then all bets are off. Wait and see I guess?
Yes, to me that is a big concern. If a 50/50 stock bond portfolio gives -1.5% real bond return, 4.5% real stock return, average real return would 3%. That means you shouldn't withdraw more than 3% IF you want your portfolio to stay even with inflation. OR with 4% withdrawal accept seeing your portfolio shrink 1% a year in real terms for several years until we get out of this low stock returns negative real bond returns period.

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Old 03-20-2012, 11:13 AM   #9
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OR with 4% withdrawal accept seeing your portfolio shrink 1% a year in real terms for several years until we get out of this low stock returns negative real bond returns period.
Is this any different than the portfolio declines shown in many 'successful' FIRECalc runs?
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Old 03-20-2012, 12:56 PM   #10
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Is this any different than the portfolio declines shown in many 'successful' FIRECalc runs?
No, not at all. It's exactly the same thing. And the situation might only persist for 10 years and then turn around.

But I know it will be somewhat disconcerting to me nonetheless, because I'll be noticing the gradual decline.

You have to pay attention to tracking inflation and real returns to actually notice, but I already do that.

I know that I really shouldn't count on doing better than keep steady with inflation over the long run, and that the 4% inflation-adjusted withdrawal rate is designed to spend down the portfolio in the worst cases.

Here is an interesting graph about what one might expect to have "left over" after 30 years. This is the "Median Bequest" - i.e. the median amount (ratio) left over after 30 years in real terms. 1 being break even in real terms. 0.5 meaning to have spent down half of the initial portfolio in real terms, etc. This assumes a 4% inflation-adjusted withdrawal rate.


from http://wpfau.blogspot.com/2012/02/wi...s-safemax.html

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Old 03-20-2012, 06:49 PM   #11
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Yes, to me that is a big concern. If a 50/50 stock bond portfolio gives -1.5% real bond return, 4.5% real stock return, average real return would 3%. That means you shouldn't withdraw more than 3% IF you want your portfolio to stay even with inflation. OR with 4% withdrawal accept seeing your portfolio shrink 1% a year in real terms for several years until we get out of this low stock returns negative real bond returns period.

Audrey
I can't quite locate it but I remember a thread with a historical study showing that IF we are going into a returns mode that resembles the returns experienced by other industrialized countries then withdrawals in the range of 1 - 3 % are about the maximum that can be expected to survive a 30 year time horizon. If I recall correctly the US past experience is an outlier on the high side.
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Old 03-20-2012, 07:49 PM   #12
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I can't quite locate it but I remember a thread with a historical study showing that IF we are going into a returns mode that resembles the returns experienced by other industrialized countries then withdrawals in the range of 1 - 3 % are about the maximum that can be expected to survive a 30 year time horizon. If I recall correctly the US past experience is an outlier on the high side.
Here's one, but I think I've seen others that looked worse...
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Old 03-20-2012, 08:28 PM   #13
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Thanks for the link and artical. Very good read. I did not realize how bad it was in Japan...75%.....not ready for that...Ready for 50% maybe but 75 might be eating rice and dog food.
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Old 03-20-2012, 09:23 PM   #14
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Here's one, but I think I've seen others that looked worse...
Thank you Midpack. I think this is the chart I remember. I don't quite understand the fifth column "% failures within 30 years" I guess I would intuitively expect the percent of failures to go up as safemax declines but that doesn't appear to be the case. For example Norway has a higher % of failures than Japan?
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Old 03-21-2012, 01:39 AM   #15
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So what we need is some global destruction and fraudulent/misleading accounting practices, and pretty soon that equity risk premium will rise back up!

I think pension funds are still trying to figure out how to recover from stricter accounting standards. At least their assumptions have gone from "ludicrously unfunded" to "merely unrealistic".

I don't know anyone who invests strictly in the Japanese stock market. Whenever I read articles crying over the demise of their favorite index, it's worth noting that (1) index reconstitution can completely swap out the original companies over the course of a decade and (2) diversify.
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Old 03-21-2012, 08:03 AM   #16
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Thanks for the link and artical. Very good read. I did not realize how bad it was in Japan...75%.....not ready for that...Ready for 50% maybe but 75 might be eating rice and dog food.
Japan in recent decades is a case where the conventional wisdom of an annually rebalanced portfolio to high equity allocations completely poops the bed. In Japan, the more bonds, the longer duration, the better.

As Nords points out, global diversification helps quite a bit. But here too, the conventional wisdom of ~20% international exposure limits the benefit from the perspective of a Japanese retiree circa 1990.
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