That's how investment manager Robert Arnott refers to the developing gap between returns institutional investors expect and what they are likely to get in the new Post-Bubble market. Mr. Arnott is the managing partner for First Quadrant LP, an investment management firm with offices in Pasadena and Boston. While most money managers are making bets on how the markets will do this year, Mr. Arnott lays out a troubling scenario for the coming decade.
The good news: his scenario is far less dramatic than the Enron implosion. The bad news: a long period of low stock returns could touch corporate America from top to bottom.
Here's his thesis, as laid out in a recent issue of Pensions and Investments, a publication for institutional investors:
• Corporations with traditional defined benefit pension plans are funding their plans using a return assumption of about 9 percent. Most people will tell you that's conservative. They expect more from their own investments and will point to the last ten years--- or more--- to prove it.
• Mr. Arnott, however, believes future returns are likely to be lower than past returns simply because we've already had a major bull market. Like Vanguard's retired founder John Bogle, Arnott says that stock returns have only a few components. One is dividend yield. Another is expansion or contraction of what investors will pay for a dollar of earnings--- the price to earnings ratio. Another is the ability to pass along future inflation. The last component is real growth in earnings and dividends.
• With dividend yields at 1.5 percent (down from 6 percent in 1982), inflation at 2.5 percent, and price/earnings ratios unlikely to expand further, real earnings growth of 3 percent would give a future total return of--- are you ready? --- Only 7 percent a year.
• That's a lot lower than the 9 percent return assumed for pension plan portfolios even though 3 percent real growth is at least twice the historical real growth rate. It's conspicuously lower than the 15 percent a year individual investors routinely received before the bubble burst in 2000.
• Now add bond yields of 6 percent. You've got a portfolio return under 7 percent--- perhaps as low as the 6.5 percent Warren Buffett suggested in a recent interview in Fortune magazine.
The rubber hits the road, Mr. Arnott says, when you connect low pension fund returns with corporate earnings. During the last ten years unusually high returns on pension plans have added to corporate earnings, often by significant amounts. Large companies like General Electric, ATT, and GTE enjoyed earnings per share boosts through the late nineties due to pension fund earnings.
Now this trend appears to be reversing. After years of positive contributions to earnings from pension performance, IBM has reduced its pension earnings assumption for 2002 from 10 percent to 9.5 percent. The change will reduce pretax income by $350 million, or 14 cents a share after taxes, according to Grants' Interest Rate Observer.
If pension fund return assumptions were forced down to 6.5 percent, corporations would have to start funding their pension plans again. Mr. Arnott estimates the earnings hit at about $50 billion. That's a 10 percent reduction of earnings in 2000, he estimates. It's a 20 percent reduction for the lower earnings of 2001. Either way, corporate earnings are facing yet another source of downward pressure.
The expectations adjustment, Mr. Arnott says, isn't limited to the shrinking world of defined benefit pension plans. Individual investors who participate in defined contribution plans such as 401(k) plans have expectations that may be even greater than pension managers.
If, as employees, we adjust our expectations from 9 percent returns to 7 percent returns, we'll have to make some hard choices. We can lower our standard of living in retirement, we can work longer, or we can increase the amount we contribute. All three actions will have an impact on our economy--- personal and national.
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