Revisiting the Many Estimates for Market Returns

Private Equity, Tropical Fruit, and Prudence On cue, The Wall Street Journal served a side dish to Tuesday's column on predictions of future market returns. The column noted that public U.S. pension funds tended to have higher estimates than other sources, both in the United States and overseas, as most expect to gain 7% to 8% annually on their portfolios. The Journal's Money & Investing story that day: "Pension Funds Pile on Risk Just to Get a Reasonable Return."

Indeed, they must--that 8% won’t be coming from 10-year Treasury notes. It can be hard to remember now, but not so long ago investors could expect high-single-digit returns without ever stepping into equities. The fixed-income securities would not all be Treasuries, so there would be some modest credit risk assumed, but one could lock in a 7% to 8% yield without too much effort.

Today, per the Journal, that theoretically all-bond portfolio from 20 years ago has been remade by public pension funds into something like this: 12% private equity, 13% real estate, 22% non-U.S. equity, 8% U.S. small-company stock, 33% U.S. large-company stock, and 12% bonds.

They do have faith in the equity-risk premium ...

As for the column’s central point, that return forecasts vary widely, Anthony Deutsch writes, “Pension plans, especially public plans, are usually assumed to be long-lived and the assumptions about long-term rates of return are therefore very long-term in nature, e.g. 30+ years. Shorter-term forecasts such as the 7 years GMO employs [the column cited GMO’s work] are thus a bananas and coconuts comparison.

Bananas and coconuts ... I like that. Better than the usual apples and oranges. At any rate, yes. Deutsch is correct. His point actually supports the column's thesis, which is that the great dispersion among asset-class estimates can be rationally explained. Some of the spread owes to motivation (as with the public pension funds), some to the difficulty of the task, and some to items such as different time horizons among the forecasters.

Finally, Michael Falk argues that pension-fund estimates should err in the opposite direction. “Pension promises have been made. Thus, the assumptive future returns should be low and contributions high to avoid the gaming of the promise as has been done. If the promise is too big, then that’s a different basket of snakes to deal with.”

That’s how we should all approach forecasts for our personal retirement portfolios! However, prudence for a pension-fund manager is imprudence to the sponsoring organization, as lower asset-class predictions mean that more money--perhaps generated by higher taxes--must be placed in the fund. And we wouldn’t want the organization to be imprudent, would we?

The Empire Strikes Back This column has on several occasions discussed the Department of Labor's upcoming regulations on retirement-savings advice. The so-called Fiduciary Standards rule requires that those who advise on retirement-related accounts, such as rollovers from 401(k) accounts into IRAs, do so in the "best interest" of clients. This contrasts with current legal standards, which is that the investment be suitable.

The difference between suitable and best interest may sound subtle, but the implication is large indeed. Moving a 401(k) account from a Vanguard target-date fund with a 0.15% expense ratio, to a wrap account with 2% annual fees, can easily be justified as “suitable.” The wrap account has a more appropriate asset allocation, the investment managers have a strong track record, and so forth. Perfection is not required, nor excellence. Just ... suitability. However, justifying that same trade as being in the best interest of the client is another matter altogether.

Predictably, the brokerage and insurance firms that fought the rule during its formulation have not surrendered. This week, assisted by the U.S. Chamber of Commerce, they filed a lawsuit opposing the new regulations. Formally, the motion targets the provision that permits investors to file class-action lawsuits against advisors. (Lawyers, please help--is that an irony? Is not this motion filed by the business group a class-action lawsuit?) Informally, the group protests that the SEC should have developed the rules, not the DOL.

Most industry insiders would agree with the latter. The SEC, however, has been paralyzed by partisan battles--politically, this issue lines up very much as red versus blue, with the opposition being Republican and the proponents being Democrat--and has been unable to proceed. Most insiders would also say that the SEC’s hand has been forced--the higher standards will not be stuffed back into their bottle and, ultimately, the SEC will follow in the DOL’s footsteps.

Stranger things have happened than this lawsuit succeeding and the DOL’s Fiduciary Standards rules being knocked down, but that would not be the way to bet.

Details, Details T. Rowe Price finds itself in a very awkward position indeed. Because of clerical error, T. Rowe Price voted in support of Dell's 2013 buyout, when it had intended to oppose that action. This embarrassing error has morphed into a potentially costly embarrassing error, as Dell subsequently was found to have underpaid during the buyout. Dell has been ordered to reimburse shareholders who were shortchanged--but only the shareholders who had voted against the buyout. Oops.

Collectively, T. Rowe Price fund owners would collect about $190 million, had the company voted to oppose. My layman’s guess is that T. Rowe Price is not legally on the hook for that $190 million because it was within its rights to vote No. It made the wrong call, and investors lost potential gains because of that mistake. That is familiar ground; such is mutual fund investing. However, an accidental No feels different from an intentional No, does it not?

According to media reports, T. Rowe Price shares that reaction. It apparently is readying an offer, from its own pocket, to reimburse its funds’ investors for some or all of that $190 million.

Although fund companies have paid from their pockets to their funds before, with money market funds that have "broken the buck," those situations were different. With the money markets funds, investors would have sustained losses had the fund company not stepped into the breach. With Dell, though, T. Rowe Price fund investors did not lose--they just did not gain as much as they might have. Reimbursing for an opportunity cost ... interesting.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.