###### Recommended Reading

I never completed my previously promised series on the equity risk premium, but for readers who are interested in the topic I would highly recommend the recently released “Rethinking the Equity Risk Premium” from the CFA Institute.

This free PDF contains a variety of interesting perspectives on the future of the equity risk premium. Note that a print version of the book is available on Amazon, and Kindle users can download a version formatted for Kindle for just $1.

###### Key Takeaway

The book has analyses from both academics and practitioners, and a variety of estimation methods are used. In my opinion, the key takeaway is that nearly all of the experts forecast future equity returns which are lower than the historical averages. Several well-argued forecasts put expected nominal equity returns in the 6%-7% per year range.

The key reason for the lower forecasts is simple. Equity valuations are higher than their average historical level. This leads to lower yields, and less potential for capital gains from further expansion of P/E ratios. Lower yields and less potential for growing valuation multiples mean that higher earnings growth must pick up the slack. Several authors provide reasons why higher-than-historical earnings growth is unlikely. Many measurable factors actually suggest lower future economic growth (demographics, debt levels, scarce resources), and economic growth is closely linked to earnings growth. I found much of the analysis to be very convincing, though not especially uplifting!

###### Implications for Investors

My thoughts after reading this document are that few investors saving for retirement are prepared for equity risk premiums and real returns as low as those suggested by many of these experts. The experience of the 80s and 90s led many investors to believe that setting aside a relatively modest sum each year would lead to a comfortable nest egg by the time retirement came around. The last decade has certainly made individual investors more pessimistic about investing returns, but I’m not sure how many fully understand the impact of lower returns on their investing goals.

The table below illustrates the amount of annual savings needed to reach a one million dollar retirement goal at several different levels of nominal annual return. This simple example assumes that an investor starts saving at age 25 and continues making annual contributions through age 65 (41 contributions). I assume that payments are made at the beginning of each year.

Expected Return | Target FV Amount | Required Annual Contribution |
---|---|---|

10% | $1,000,000.00 | $1,863.36 |

8% | $1,000,000.00 | $3,297.68 |

6% | $1,000,000.00 | $5,715.90 |

4% | $1,000,000.00 | $9,632.09 |

2% | $1,000,000.00 | $15,658.71 |

Notice how much higher the required annual contribution becomes when we move from a 10% return to a 6% or even a 4% return! Regardless of your retirement goal, the percentage of your income that you need to invest in a world with a sub-6% expected equity return must be substantially higher than it would be with 8-10% expected equity return. In a low return world, saving for a comfortable retirement is an expensive project! The projections of many of the experts suggest that we are living in an age of expensive retirement.

*Calculations:*

I calculated the values in the table above using the Future Value equation for an Annuity Due. An “Annuity Due” assumes contributions are made at the beginning of each period rather than at the end of the period. The equation is shown here:

Solving for PMT gives:

This same calculation can be done using the “PMT” function in Excel or GoogleDocs. An example GoogleDocs spreadsheet is available here. You will need to save a copy if you would like to modify the spreadsheet.

###### Are the Experts too Pessimistic?

Predicting the future is impossible. It may be that these low estimates for future equity returns underestimate the potential for innovation and economic growth.

Whenever I get overly pessimistic about our economic future (usually the result of reading too much Jeremy Grantham or Bill Gross), I re-read the excellent and optimistic essay on economic growth by Paul Romer. This quote is my favorite:

Every generation has perceived the limits to growth that finite resources and undesirable side effects would pose if no new recipes or ideas were discovered. And every generation has underestimated the potential for finding new recipes and ideas. We consistently fail to grasp how many ideas remain to be discovered. The difficulty is the same one we have with compounding: possibilities do not merely add up; they multiply.

Despite the possibilities for economic growth through accelerating technological change, I nevertheless believe that the arguments forecasting a lower equity risk premium and lower total return are compelling. It may turn out that the pessimistic estimates are wrong, but, if so, an overly cautious investor who invests a large percentage of income to save for retirement will still be rewarded with an earlier or more comfortable retirement.