Risky Business

Investors face more risk for the same reward

By Julia Moriarty and Jay Kloepfer

Guest Columnists

With interest rates historically low in the United States and abroad, fund sponsors reluctant to lower their return expectations face one of the most difficult investing environments in history.

To measure just how difficult, investment consulting firm Callan Associates decided to examine what investors need to do to achieve a 7.5 percent return with the least amount of risk possible. Using forward-looking capital market projections the firm compiles, investors in 2015 needed to take on three times as much risk as they did only 20 years ago. 

The same theme of much greater risk for the same return holds true with more recent data. Also, portfolios seeking to achieve that performance have become more complicated and expensive over that period, allocating more to assets such as private equity and emerging market stocks.

In 1995, our expectation for broad U.S. fixed income was exactly 7.5 percent. We found a 100 percent fixed income portfolio was an efficient way to achieve that return.

But in 2005, investors looking for that same return needed a portfolio with just 52 percent in fixed income and the rest in riskier, return-seeking assets. And by 2015, the same return required a portfolio with just 12 percent in fixed income.

Exhibit 1

Same Return, Increasing Risk

Projected portfolio returns over past 20 years

At the same time, the risk of the portfolio significantly increased. The standard deviation for the model portfolio of 100 percent fixed income was 6 percent in 1995, compared to 17.2 percent for the model portfolio just two decades later. Standard deviation is a broad measure of risk, so the headline is that in just two decades, the risk required to achieve a 7.5 percent return nearly tripled.

Our projections for virtually all asset classes have come down gradually over the years. The unnerving consequence of lowering capital market projections is that if an institutional investor does not lower its total fund return requirement, that investor will have to keep taking on more and more risk.

This shift in the investing environment stems from the secular decline in interest rates and bond yields that has taken place over the last several decades and accelerated over the last decade. After the Global Financial Crisis, the world financial system entered an era of unprecedented monetary easing.

Governments and central banks started a unified fiscal and monetary response, driving interest rates to zero to keep liquidity going. The goal was to push investors into riskier assets because those are the ones expected to lead to economic growth. The thinking was: Don’t let people sit on piles of money; instead, make it so painful that they have to go invest.

One can argue that this zero-interest rate policy kept the world financial system from going into a deep, dark tailspin from which it may have not yet emerged. However, investors have to live with this overhang of historically low interest rates. For example, an all-bond portfolio in 2015 was expected to produce a 3.0 percent return compared to the 7.5 percent expected 20 years before that, a stark sign of the dramatic decline in interest rates.

With all these factors, fund sponsors face a particularly tricky set of challenges. Lowering their return expectations means the plan’s funded status will drop and the amount of money that must be contributed will have to go up for a given level of benefits. A higher required contribution means less spending elsewhere in the budget, or perhaps a tax hike. Alternatively, a lower funded status could force a cut in benefits. Changing the return target has impacts measured in real dollars and this is a dilemma that a lot of our clients face.

For the full story behind Callan’s research, readers are invited to read Callan’s White Paper at https://www.callan.com/research/files/1267.pdf.

The views expressed herein do not constitute research, investment advice or trade recommendations. 

Julia Moriarty

Jay Kloepfer

About the Authors:

Jay Kloepfer is executive vice president and director of Capital Markets Research at Callan Associates. Julia Moriarty is a senior vice president and co-manager of Capital Markets Research at Callan. Both are based in San Francisco.