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© Copyright 2000 Rogers Media. The following article first appeared in the April 2001 edition of
BENEFITS CANADA magazine.
Equities evaluation
A Yale University economics professor forecasts a zero return on equities over the next 10 to 20
years. What can pension funds do?
By Barbara Clapham
When investing in equities, most asset managers assume their investment will earn a certain rate of return over
a given time period. How much they expect this return to be depends largely on their beliefs about the current
level of the market and the economy in general.
You may think that over the next 10 to 20 years equities will return 5%, 8%, even 10% or more on an annual
basis. But what if this figure is actually 0%? Robert Shiller believes there is a strong possibility that
equities will, in fact, return zero, or close to that over the next 10 to 20 years.
Shiller is the Stanley B. Resor professor of economics, Cowles Foundation for Research in Economics at Yale
University and author of Irrational Exuberance. When he was writing that book,which was published in
early 1999, the Dow Jones Industrial Average was just over 10,000. Although it subsequently increased, the
Dow has since fallen back to roughly the same level that it was at in early 1999.
While most investors think it's inconceivable that the Dow might still be at this level in 2020, Shiller
disagrees. "It is certainly not impossible," he says. "There can easily be a 20-year period without any
growth in the stock market. When it starts out at such a high level it is quite a plausible scenario."
OVERVALUED MARKETS
Don Lindsey, president and chief executive officer of University of Toronto Asset Management, agrees that
North American markets are overvalued. Looking at the fundamentals, excessive leverage assumed by many
companies over the past few years will likely lead to an increase in defaulted debt and either low profit
growth or a decline in profit. As well, Lindsey notes that on a historical basis "there is a reversion to
the mean in the markets, and given the high returns in the '80s and '90s, it is only prudent to assume
returns are going to be significantly lower going forward."
Lower returns in North America don't necessarily mean a lack of opportunities elsewhere, though. Corporate
restructuring and the monetary union in Europe should start to pay off with growth on the continent. And
although the recovery in Japan has been a slow and painful process, Lindsey thinks that "there are extreme
values to be found" in that part of the world.
Irshaad Ahmad, head of investment consulting at William M. Mercer Ltd. in Toronto, also thinks that we are
looking at lower equity returns over the next 10 years or so. However, he expects returns to be in the
single digits.
THREE-STEP PLAN
Pension funds can hope that Shiller is mistaken. But it's safer to anticipate a lower level of return from
the equity portion of their asset mix. In this light, what action should pension funds take? Ahmad believes
three main areas need to be reviewed:
1. Discount rate. Lower future returns combined with lower interest rates suggest that managers and plan
actuaries should discuss whether the discount rate being used is still appropriate.
2. Pension surplus. For a long time plans were awash in surplus, leading to contribution holidays and
concern that the surplus exceeded Revenue Canada limits. Plans for spending the pension surplus should be
reconsidered and the focus switched to determining how long the surplus can last in a low return
environment.
3. Investment policy. Small to mid-size plans have not traditionally allocated funds to alternative
investments such as hedge funds and private equities. These options must be considered, as should global
bonds, corporate bond mandates, high yield bonds, emerging markets and U.S. small cap stocks.
On a final note, this is my last Investment Strategies column as I am moving on to another
opportunity in the industry. I wish you all the best.
Barbara Clapham is editor of Canadian Investment Review
and a contributing editor to BENEFITS CANADA.
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