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Aon Retirement and Investment Blog

Windblown Voyage: Expected Returns in Volatile Markets

We see three sailors in three sailboats, racing in choppy waters and strong westerly crosswinds towards an island that is 30 miles due north. The sailors take different approaches to reaching their destination:

  • Sailor A raced to the same island yesterday when there was no crosswind. He sets course due north, confident that if he maintains this direction he will finish in good time.
  • Sailor B starts by heading due north, but keeps his eye on the island and adjusts every few minutes to ensure he is still heading towards it.
  • Sailor C looks at the wind and waves and chooses a course that initially takes him northwest. Like B, he also adjusts his course every few minutes. 
Who will get there first?

"Our Expected Return on Assets is a long-term assumption based on a 30-year time horizon. We don’t feel the need to reset it every quarter or even every year.” We hear this comment from clients nearly every day in our work. Corporate controllers, investment committees, and treasurers for governmental pension plans frequently need to “predict the unpredictable” by stating their expected long-term portfolio returns. This contentious assumption serves as the basis for the discount rates that drive pension contributions (governmental and non-ERISA plans), assumed investment returns for pension accounting expense (corporate plans reporting under US GAAP), and spending models for endowments and foundations. While the expected return assumption is generally based on a long-term view, its key importance is that it drives short-term cash and accounting costs.

At Aon Hewitt we advise thousands of clients across the globe on setting this assumption, using our in-house model. We revise our own assumptions each quarter based on changing inputs:
  • Bond returns are generated from current yield curves, using an interest rate model that captures possible future yield curve paths and returns.
  • Equity returns are derived from current and long-term expected earnings yields, inflation, and the portion of earnings distributed to shareholders. Calculations are performed across seven global regions, and then aggregated to get global returns on a country and currency-adjusted basis.
  • Alternative asset class returns are modeled based on factors such as inflation, fees, current market valuations (real estate, private equity), spreads (credit), short term yields, and achievable alpha and illiquidity premia (hedge funds and private equity).
Why quarterly updates? Because equity valuations and bond yield curves are essential inputs to our model, and we are continually reminded how volatile they are.
  • Consider US Treasuries (all data sourced from the U.S. Department of the Treasury). The year 2016 began with the 30-year Treasury yield at 3.02%. Yields plunged to 2.3% on June 30, plunged further in July and then spiked up back to over 3% in late November. A holder of a 30-year Treasury bond saw the value of their holding surge by nearly 20 percent from January to early July, and then plummet back to earth as of early December. Three percent would have been a perfectly reasonable return expectation for this holder on January 1, or November 30. When yields bottomed out around 2.1% on July 8, only an improbable pattern of future yields and reinvestment could have resulted in a 3% return over the subsequent 30 years, and an investor who purchased a bond on that date would be sitting on a large loss in early December.
Unchanging long-term expectations for what bonds and equities will return imply that current bond yields and equity valuations are irrelevant to future returns. To us, fluctuations in those factors are not just “noise.” They provide critical inputs that we reflect quarterly in our forward-looking views. Our eyes are fixed on our long-term expectations, our hands firmly on the tiller.

Sailor C, the most experienced of the racers, reaches the island quickly. Sailor B arrives much later, complaining about the wind. Sailor A never shows up. Sailor C leads the search party.

Alan Parikh is an Associate Partner and member of Aon Hewitt’s Capital Market Assumptions Committee based in Lincolnshire, IL.

Content prepared for U.S. subscribers, but available to interested subscribers of other regions.

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