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Home Publications Blogs Beat the Press Economists on Stock Returns: It Depends on the Weather or Maybe Politics

Economists on Stock Returns: It Depends on the Weather or Maybe Politics

Friday, 04 March 2011 05:46

It would be nice if the answers that economists gave us on economic issues did not change when the political environment changed. Unfortunately, we don't live in such a world. This can be seen very clearly in the current debate over the assumption on rates of return that public pensions should make for the assets they hold in stock.

Most economists today seem to be lining up on the side that pensions should only assume that stock will provide the same rate of return as Treasury bonds. Even though the expected nominal return on stocks might be 10 percent, these economists argue that because of the risk associated with stock returns public pension funds should only assume the rate of return on risk free Treasury bonds, roughly 4.5 percent.

The counter-argument is that state pension funds can essentially be indifferent to the risk of market timing. If the market is depressed for a few years, the state pension fund would still have adequate assets to pay all benefits. There would only be a problem if the market remained permanently depressed, which is not plausible if the widely accepted projections for long-term economic growth prove accurate.

This lower rate of return makes a huge difference in the size of pension liabilities. This change in accounting, coming at a time when state budgets are hard-pressed due to the recession, would create substantial pressure to reduce pension benefits and possibly eliminate defined benefit pension plans altogether.

It is interesting to note that the economists' concern with pension fund accounting just happens to coincide with a major push by the right-wing to attack public sector workers and especially public sector pensions. State pensions have been assuming 10 percent nominal returns on their pension's stock holdings for decades. This fact never seemed to trouble economists previously.

Interestingly, many economists had argued the exact opposite position in the context of Social Security privatization. Andrew Biggs, one of the economists who has been very prominent in the debate for lowering the return assumptions on public plans, explicitly argued for assuming a high rate of return for the stock held in privatized Social Security accounts. Other proponents of privatization took the same perspective, which was the main benefit of their proposal.

Even advocates of preserving the current Social Security system wanted to assume a higher rate of return for money held in stock, albeit for stock held in the Social Security trust fund. Two of the country's leading experts on Social Security, Henry Aaron and Robert Reischauer, both explicitly called for putting part of the Social Security trust fund in the stock market to take advantage of the higher rates of return offered by stock. President Clinton made the same proposal.

It is worth noting that these plans for putting Social Security money in the stock market were made near the peak of the stock bubble, when price to earnings ratios were approaching 30. In this context, they were making absurd assumptions about the prospect for future returns, as some people pointed out at the time. By contrast, now that the market has plummeted from its bubble peaks and price to earnings ratios are close to their long-term average, it is plausible that the market will provide its historic rate of return.

If economists were consistent, they would apply the same methodology for assessing stock returns in the context of Social Security privatization in the late 90s as they apply to public pension funds in the current crisis. This does not appear to be the case.

Comments (8)Add Comment
written by foosion, March 04, 2011 5:29
Those attacking your paper on state pensions have accused you of predicting lower stock returns in the context of social security privatization and higher stock returns in the context of pension funding. Is your answer the difference in p/e ratios?
written by izzatzo, March 04, 2011 7:37
If economists were consistent ...

Three economists walk into the Game Theory Bar. Each one asks the other two what they're predicting these days and each one says it depends on what the other two are predicting.

The bartender arrives, separates them and declares to each one that if the prediction of any one economist is wrong, all three will be fired, at which point all three immediately converge on the same prediction and order a round of Nash Equilibrium to celebrate.
written by PeonInChief, March 04, 2011 8:27
Please note that they also expect much higher returns for 401ks, as they can't argue that those are better retirement vehicles unless they claim very high returns--to the consternation of many people expecting to retire on them.
Shiller's 10-Year PE Ratio
written by ellen 1910, March 04, 2011 8:47
I'm not supporting the critics (how could I? I didn't read them), but --

The current PE ratio arrived at in the CEPR paper -- based as it is on total "market value of domestic corporations" divided by earnings after taxes -- would not seem to be relevant even if the Flow of Funds data were accurate.

The universe a prudent fund board can invest in is pretty much limited to the S&P500 -- not all "domestic corporations." Shiller's 10-year smoothed PE ratio for the S&P500 is currently around 23. Historically, that figure suggests an annualized return over the next 10 years of something under 4%.*

Why would or should prudent pension fund actuaries expect anything different?

* As to lengthier time periods, their outcome is difficult to predict, since any prediction is very hard especially about the future.
written by bmz, March 04, 2011 9:45
The argument that equity returns should equal long-term treasuries is economically absurd. Why would anybody ever invest in equities with their higher risk if they did not expect higher returns as well. I would love to cross examine one of these morons.
Market returns
written by Tony, March 04, 2011 1:20
The problem with pensions, is that they assumed that the 80's & 90's are the normal returns. While it is true, that the average return for stocks is about 8% over the long haul, the market has never given a average return since 1900. The market either performs better then the average, like from 1896-1906, 1921-1929, 1949-1966 and 1982-1999, or well below average like 1906-1921, 1929-1949, 1966-1982 and 2000 to the present. I have no problem with pensions planning 8% returns over the long haul, if they build a surplus during the segular bull markets, to make up for the lower then normal returns that you get during a segular bear market, but they never did this. They say that the average return of a stock, is the GDP growth plus dividend yield. Since GDP since 2000 has averaged 2.0% and the dividend yield for the S & P 500 is now at 1.7%, and with treasury yields at around 4.5% on a 30 year government bond, a 4% annual return is what pensions and most investors should expect for the next several years. Pensions are not prepared for this. And as far as Social Security is concerned, the time to have made it private was during the early 1980's, when the average stock was yielding around 6%. For better or for worse, we passed at this opportunity, and I do not believe that we try this again, unless we were to make really major changes in social security, which very few people appear to want to do. So lower returns for retirees is the only outcome that I see is possible.
stock market returns
written by bill, March 04, 2011 7:23
Dean, you've previous stated that the stock market can only be expected to grow as fast as profits, and that profits can only grow as fast as the economy in the long run:

"These are the most widely used projections; but we can be more optimistic, and say that profits will grow as fast as the economy is projected to grow: 2.3% annually, adjusting for inflation. (Over the long run, profits do not grow faster than the economy as a whole).

This implies that shareholders can expect, on average, a 2.3% annual increase in the price of stocks over the long run -- at best. Now add to this the average dividend payment: currently about 2.0%. This gives us a total return on stocks, after inflation, of 4.3%."

How is this c/w your acceptance of a 10% annual return now?
written by zinc, March 06, 2011 7:30
As you point out, predicting the future of pension returns has a horrible political and moral dimension that has been and is one of the root strategies of wealth redistribution in the US.

Pensions that were adequately funded in an earlier time have been systematically looted by the redefinition of the "expected" rate of future returns from a Graham and Dodd style world to the Glassman world. That is why the pensions in the US are now in peril.

From 1982 until 2000, the value of stocks rose as a result of the steep drop in comparable treasury rates combined with a change in the psychology of expectations of dividend growth prospects. Look at today's market, priced mostly on a comparable basis with miserable bond returns combined with high future growth expectations, rather than the long term historical growth in dividends.

In the end, equities are only worth the net present value of their cash payouts which is correlated with comparable treasuries and adjusted for risk. As you point out all the time, the Federal Reserve has abused the treasury yield curve as a blunt instrument for influencing all manner of political and financial industry objectives, in contradiction of prudent and legitimate financial stewardship.

IMO, anyone thinking today's ZIRP policy is an indication of financial health is mistaken. It is the result of 30 years of monetary and fiscal blunders. Tricking people into accepting risk has been a very successful strategy for corporate America, the Financial Services Industry, and the corrupt government. Now if we can only get the fools to accept cuts in Social Security we will be home free, never having to repay the baby boomer savings we spent.

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.