Declining Projected Returns

I read in The Wall Street Journal on Monday (March 1, 2010) (http://online.wsj.com/article/SB10001424052748703316904575092362999067810.html?KEYWORDS=calpers++rate) that CalPERS (the California Public Employees’ Retirement System) is considering reducing the projected rate of return used to make investment decisions. This is further validation of a growing sense in the investment community that investment returns are likely to be lower than they have been historically. (Note: The Pew Center on the States reports the most common projected rate of return among public pensions in the U.S. is 8%.)

Since 2003, CalPERS has assumed that the value of its stock, bonds and other holdings would increase by 7.75% per year. However, the board has been advised by its investment consultants that this is not likely to occur. BlackRock, a leading investment company, suggested that the huge pension would be “lucky to get 6% on your portfolios, maybe 5%.”

The lower projections will result in increased contributions needed from employees and local governments to meet future payouts promised to retirees and their beneficiaries. This is not good news in a state that is already facing dire financial conditions.

But what does it mean to you? Well, the same returns that affect massive institutional investors like CalPERS (and Oregon PERS by the way), affect individual investors like you.

The CalPERS portfolio is allocated broadly across multiple asset classes. You can see this on their web site. (http://www.calpers.ca.gov/index.jsp?bc=/investments/assets/assetallocation.xml) As of December 31, 2009, the CalPERS portfolio included 66% in global equities (stocks), 23.5% in global fixed income (bonds), 6.8% in real estate, 2.4% in inflation linked securities and 1.3% in cash.

Most economists expect income tax rates to rise from their current levels as the government seeks additional revenue to reduce the federal budget deficit and pay for social programs. Tax rates on dividends, interest and capital gains (the sources of investment income) are likely to increase by many percentage points.

This means that investors will give up more of their returns to the government. If we assume the CalPERS recent projected return of 7.75% and a blended tax rate of 30%, then the after tax return is 5.43%.

Now let’s imagine that the rate of inflation over the next 25 years runs at 4%. I realize that this is considerably higher than the current rate. But it is consistent with historical rates and it very likely understates the rate we will actually experience.

Now the 5.43% return, after subtracting inflation, is 1.43%. (This is an approximation. The actual inflation-adjusted return is actually slightly lower.)

We have, thus far, ignored expenses and fees. These costs include advisory fees, management expenses, commissions, etc. For investors in actively managed portfolios, these expenses can easily top 2.25%. (Note: Cascade Wealth Management builds passive portfolios which typically have total expenses and fees of less than 1%.) This would wipe out what’s left of the returns that have been adjusted for taxes and inflation.

So, investors need to consider carefully how lower future returns will affect them. If you are retired and rely on your investments for income, review the rate at which you are drawing from your portfolio. You want to make sure your investments support you for the rest of your life. If you are still working, make sure you are saving enough to meet your income needs in retirement.