The three questions that dominate investment

The writer is a financial journalist and author of ‘More: The 10,000-Year Rise of the World Economy’

Three linked questions are at the heart of investment decisions today. What is the risk-free rate of return that investors can now secure? What future return is it reasonable to expect? And what is the prudent level to take or “draw down” from a pension fund or saving scheme? The answers to those questions affect everyone from charitable foundations through giant pension funds to ordinary 60-year-olds contemplating how best to use their pension pot.

None of these questions is easy to answer. Take the risk-free rate. This could be defined as the return on short-term bank deposits (virtually zero at the time of writing), the yield on two-year Treasury bonds (0.6 per cent) or 10-year bonds (1.44 per cent).

All of these are very low by historical standards and much lower than the current rate of inflation (6.8 per cent in the US). Investors seem bound to see the value of their money erode in real terms and if they sell the bonds before maturity, there is the risk that they will lose money in nominal terms as well.

Should investors try explicitly to hedge their portfolios against higher prices, then inflation-protected 10-year Treasury bonds yield minus 1 per cent, guaranteeing a real loss if held till maturity. As the joke goes, the risk-free return has turned into return-free risk.

The consequences of these very low yields are immense, because other assets are priced in relation to the risk-free return. For example, companies that borrow in the bond market pay a spread over the government bond yield to reflect the risk of default.

As government bond yields have fallen, so has the cost of corporate borrowing. Pension funds use the corporate bond yield when calculating the cost of paying retirement benefits; the lower yields fall, the greater the cost of meeting future liabilities.

The rise in the accounting cost of meeting pension liabilities explains why so many schemes are in deficit even though stock markets have been strong performers since the 2008 crisis. It also explains why many scheme sponsors try to match their liabilities by buying bonds. And in turn, this explains why there are still plenty of buyers of bonds at very low yields.

Given the unattractiveness of prospective bond returns, it is not surprising that many investors would prefer to rely on equities. But what return are equities likely to deliver? The standard formula is to add a risk premium to the government bond yield. Historically, this has been around 4 per cent globally, according to the work of Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School. Adding 4 percentage points to the yield on the inflation-linked bond of minus 1 per cent would give us an expected real return from equities of 3 per cent.

But are investors really expecting equity returns to be that low? It seems unlikely, given the way that they have piled into stocks even in the face of the pandemic. Instead, if investors believe future returns from equities to be high, that logically means they expect that a very high risk premium is needed from the asset class. In other words, they think equities are a lot riskier than normal. Again, that does not seem to be a mainstream view.

However, a rule-for-thumb for markets is that when current valuations are high, future returns will be low. In America, equity valuations are very high, as measured by the cyclically adjusted price-earnings (Cape) ratio developed by Robert Shiller of Yale University, which compares share prices with the average corporate earnings of the past 10 years. The current Cape ratio is 38, a level that was only higher during the peak of the dotcom bubble of 2000.  

But if future returns are going to be low, investors face some very difficult decisions. Pension schemes will have to ask for more money from their corporate sponsors or, in the public sector, from taxpayers. Individual workers trying to assemble a pension pot need to save more now, and spend less; an approach that governments trying to boost their economies may not entirely welcome.

By the same token, if future returns are going to be low, then the pace of drawdowns must be reduced, too. Charitable foundations have often followed a 5 per cent rule when deciding how much income to take from their foundations. That looks too high. Similarly, retirees with pension pots may need to draw down less than 4 per cent a year to ensure their money does not run out. Investors are bombarded with information about which stocks or mutual funds to pick in the hope of beating the market. Too little time is devoted to discussing how much money they should set aside in the first place.