Reaching for Returns

By Charlie Bilello

14 Oct 2021


That’s been the annual return assumption of pension funds for decades.

What mix of assets is required to generate such a return?

The answer to that question has changed dramatically over the past 40 years. Let’s take a closer look…

January 1981

In 1981, short-term Treasury bills were yielding over 15%, near their highest level in history. 1

You could have put 100% of your assets in Treasury bills and achieved a return of more than double the 7.5% target.

January 1986

By 1986, interest rates had been cut in half, with Treasury bills now yielding 7.1%. To hit 7.5% you now needed to incur a little volatility, and move a portion of your portfolio into higher yielding 10-year Treasury bonds (9.1% yield at the time).

The new mix: 78% Treasury bills, 22% Treasury bonds.

January 1991

Five years later, interest rates had moved lower once again, with 3-month Treasury bills now yielding 6.2% and the 10-year Treasury at 8.0%.

The new mix: 29% Treasury bills, 71% Treasury bonds.

January 1996

By 1996, the move lower in yields had become more pronounced, with Treasury bills now yielding 5% and Treasury bonds yielding 5.6%. For the first time, this necessitated an allocation outside the safety and security of government bonds. At the time, BBB-rated corporate bonds were yielding 7.5%, meaning a 100% allocation that asset class was necessary to hit the target.

The new mix: 100% BBB Corporate bonds.

January 2001

In 2001, the story remained very much the same, with Treasury yields around 5% and BBB corporates moving up to 8%. This gave some room to include Treasury bonds in the portfolio again while still hitting the 7.5% target.

The new mix: 15% Treasury bonds, 85% BBB Corporate bonds

January 2006

By 2006, yields had moved lower once again, with the 3-month at 4.2%, 10-Year at 4.5%, and Corporate Bonds at 6.1%. With all three below the 7.5% hurdle, a move into equities was now required (note: using a 10% return assumption for U.S. equities).

The new mix: 66% Corporate bonds, 34% Stocks

January 2011

By 2011, the Fed’s 0% interest rate policy was in full effect, and Treasury bills were yielding almost nothing.

Corporate bond yields had moved down to 6.1%, requiring more in equities to hit the target.

The new mix: 63% Corporate bonds, 37% Stocks

January 2016

By 2016, Corporate bond yields had moved down to 5.5%, and the shift into equities continued.

The new mix: 55% Corporate bonds, 45% Stocks

January 2021

Which brings us to the start of this year, where short-term rates were once again near 0%, Treasury bonds at just over 1%, and Corporate bond yields at record lows (3.2%). For the first time, more than half the portfolio would need to be in equities to have a chance at hitting 7.5%.

The new mix: 36% Corporate bonds, 64% Stocks

A 40-Year Transformation

Over the last 40 years, we’ve seen a complete transformation in the portfolio mix necessary to hit a 7.5% return, from 100% Treasury bills in 1981 to 100% in Corporate bonds in 1996 to more than half of the portfolio in equities today.

Note: Assuming 10% Equity Return

The result has been a significant move up the risk curve, with higher volatility and the potential for much larger drawdowns.

And this assumes a 10% return for equities, which is far from a guarantee going forward. At current valuation levels, the historical precedent has been below average future returns (see here).

This is important because even if we move the equity return assumption down slightly to 8%, that would require a portfolio of nearly 90% equities.

Note: Assuming 8% Equity Return

And if we use more pessimistic assumptions (ex: Vanguard’s estimate of 2.4%-4.4% for U.S. equities), hitting 7.5% becomes mathematically impossible.

Reaching for Returns

The 40-year decline in interest rates has put investors today in a difficult position. They are forced to either reach for higher returns or accept the reality of lower ones.

Neither choice is optimal:

  • Reaching into equities requires the ability (both psychologically and financially) to withstand a much more volatile path (see here), with no guarantee that path will be rewarded with higher returns (see here).
  • On the other hand, lowering your return expectations may require some combination of the following: saving more, spending less, or retiring later.

These options may not be palatable, but they are realistic, and any successful plan needs to be grounded in reality. Confront the world as it is today and be prepared to adapt as it changes tomorrow. That’s the best you can do as an investor.

1. In this post, “Treasury bills” represent the 3-Month US Treasury Bill, “Treasury bonds” represent the 10-Year Treasury Bond, and “Corporate bonds” represent the “Moody’s Seasoned Baa Corporate Bond Yield.” Data source: St. Louis Fed.

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