The expected rate of return for equities: a ten-year and a thirty-year forecast

Business Economics, Oct, 2003 by Henry Townsend

In their defined benefit plans, most companies assume a rate of return for the assets that accords with the historical return on equities. By analyzing the sources of return, however, it can be easily seen that a repetition of that historical performance is improbable. A model is presented of the total rate of return for equities, based on the growth of per capita GDP. Forecasts of returns over the next ten and thirty years are presented that are much lower than those commonly assumed.

Companies with defined benefit pension plans must assume a long-term (10-plus years) rate of return for the assets in these plans. In mid-2001, 358 companies in the S&P 500 index had defined benefit plans. The expected rate of return for all but a few was between 8 and 11 percent, with a median expected rate of return of 9.2 percent (Zion 2002, p.12). In the 2003 annual reports for 100 of the largest companies with defined benefit plans, the mean expected rate of return was 8.9 percent; very few were less than 8 or more than 10 percent (Milliman 2003). On average, equities make up about two-thirds of plan assets, with bonds making up most of the remainder (Zion 2002, p. 85). The focus of this paper is on the expected rate of return to equities. But we should not forget that the overall return to pension plan assets includes the returns to bonds, whose longer-term returns historically have been lower than the return to equities. Therefore, the return to equities assumed by these companies is higher than the expected asset returns described above.

The rates of return expected for pension assets resemble the returns expected for equities among investment professionals. Thus, the mean 30-year stock market return forecast by 510 finance and economics professors in August 2001 was 9.1 percent, with half the returns falling in the 8.0 to 10.5 percent range (Welch 2001, p. 4). Nine percent is also approximately the historical long-run rate of return for equities. The compound average growth rate of annual total return to investment in the stock market, including reinvested dividends, has been

8.9 over the last 132 years (1871 through 2002). (1) But if we analyze the sources of total return to investment in stocks, both before and during the recent boom, we will see that achieving an average total return of nine percent or better for equities over the next 30 years implies a scenario that many will think unlikely.

The Sources of Total Return

The total annual return on stocks for a given year t, TR, can be defined as follows:

(Identity 1) [TR.sub.t] = ([P.sub.t] [DPS.sub.t]/[P.sub.t-1],

where P is the price of the stock at the end of the year, and DPS is dividends per share paid during the year.

The same definition of total return may also be represented as the product of three factors: growth in yearly earnings per share, EPS; growth in the price-earnings ratio, PE (the end-of-the-year price P divided by EPS); plus the effect of reinvesting dividends:

(Identity 2) [TR.sub.t] = ([EPS.sub.t]/[EPS.sub.t-1] x ([PE.sub.t]/[PE.sub.t-1]) x (1.0 [DPS.sub.t]/[P.sub.t])

Table 1 shows the average percentage rates of change for total return and these three factors over various periods. Thus, over the whole period for which we have growth data, 1872-2002, while stocks returned an average compound rate of total return of 8.8 percent, EPS grew at 3.3 percent, the PE ratio grew at 0.7 percent, while reinvested dividends contributed 4.6 per cent. The table includes data on the recent stock market boom, which we somewhat arbitrarily begin at the end of 1978, picking up the 1979 and 1980 returns of 18 and 31 percent, and ending in 1999, before the declines of 2000, 2001, and 2002. Data on pre-boom history, 1872-1978, and 1979-2002 are also included for comparison. We also include in [square brackets] the proportions of total return in each period due to each of the three sources. (2)

Note how over the 107 years 1872 through 1978, total return was due to two sources, earnings growth and reinvested dividends; the contribution of PE growth to total return was a negative factor, minus 0.4 points a year. But the great market rise beginning in 1979 was due not only to strong earnings growth, more than double the historical norm through 1978, but also to a great change in investors' perceptions of the stock market. At year-end 1978, the PE was 7.8; by year-end 1999 it was 30.5. Investors in 1999 were willing to pay four times as much as in 1978 for a dollar of earnings. PE growth, which contributed less than nothing to total return over the whole pre-boom period 1872-1978, has made up 48 percent of total return thereafter. The year-end dividend yield fell from 5.3 percent in 1978 to 1.1 percent in 1999. From 1979 through 1999, reinvested dividends made up only 20 percent of total return rather than the pre-boom average of 63 percent.

A Reasonable Forecast of Total Return

What is a reasonable return to expect for the next 30 years? Dividend yields have fallen below two percent since 1996. For dividends to contribute more to longterm returns, either stock prices have to fall, or the ratio of dividends to earnings (the payout ratio) has to increase. In the latter event, since a dollar more in dividends means a dollar less in retained earnings, we would expect total returns to be approximately unchanged. (3) A belief in a prolonged contribution to total return from increases in the PE ratio means that investors will continue to increase the amount they are willing to pay for a dollar of earnings from its present level, already higher than at any time in history before the nineties. Just to continue for 30 years, the small 0.7 percent average PE growth from year-end 1871 through 2002 means a PE in 2032 of 39. If this scenario is discarded, we are left with increases in earnings. With the year-end 2002 dividend yield of 1.8 percent, earnings would have to grow at nearly 7 percent if total returns are to equal their 8.8 percent historical average. Is this possible?