Low returns - get used to it

By BRENT SHEATHER

Across a broad range of investment markets returns are falling, interest rates at home and in the US are touching record lows and international sharemarkets have recorded two disappointing years in a row.

The bad news is that lacklustre returns will not be a short-term phenomenon.

For those saving for retirement, prospective returns in the next 10 years are likely to be much lower than they were 10 or 20 years ago, as we will not have the same favourable "tail wind" produced by falling inflation, which enhances returns on both bond and share markets.

In 1990, 90-day bills yielded 14 per cent.

Today, the figure is only 4.7 per cent.

One of the best games in town in the 90s was owning ultra-long-term bonds. With interest rates moving steadily lower, 30-year US treasury bonds returned almost 10 per cent a year in US dollars in the 1990s - not a bad effort when inflation was only 5 per cent.

Today, 30-year Government bonds yield 5.2 per cent, inflation is 2 to 3 per cent and interest rates are as likely to rise as to fall.

And while returns may be down, volatility has increased.

Thus, the markets' appetite for risk is declining as some of the biggest investors in higher-return sectors like high-yield bonds, venture capital and emerging markets - chastened by large losses after September 11 - scale back their operations and in some cases get out of the business completely.

As liquidity contracts, professionally managed investment portfolios are becoming more conservative; more in bonds, less in shares.

Late last year a large (£2.3 billion) UK pension fund for Boots the Chemist employees announced that it had sold all its shares and bought long-term AAA-rated bonds instead.

The cult of shares is being replaced by low-risk bonds.

Safe and steady - just the thing for increasingly mature funds and their members in uncertain times. The combined effect of these influences has been to reduce returns.

The graph shows the actual returns investors with a balanced portfolio (for simplicity's sake, 50 per cent NZ bonds, 50 per cent overseas shares) received in the past 20 years and what they will earn in the next 10 years.

It assumes interest rates stay where they are now and there is no change in price-earnings multiples - a frequently used measure of share prices.

Inflation averaged around 3 per cent a year in the 90s and is likely to continue at a similar, or slightly lower, rate in the next decade.

Real returns will therefore probably be less than half of those achieved in the 90s.

It is tempting to believe that the impact of these changes will mainly be felt by someone else - layoffs on Wall St, perhaps, or a decline in Porsche sales, but it will be business as usual for the man and woman in the street.

Tempting, but wrong.

For New Zealanders saving for retirement, low interest rates and becalmed sharemarkets are a two-edged sword.

Not only do they affect the terminal value of the sum you are likely to be able to save by the time you retire, but they will also reduce the return generated by that sum once you have stopped work.

Put very simply, the cost of retirement is going up, sharply.

The golden days of double-digit sharemarket returns in the 1990s depended on expanding price-earnings multiples to supercharge returns. In other words, the amount investors were willing to pay for shares, in relation to company earnings, kept on rising.

Today, multiples are falling.

To see how important this effect is over the longer term, consider the performance of the world's largest sharemarket, the United States, from 1961 to last year.

In the first 20 years of that period, 1961-81, sharemarket returns averaged only 7.5 per cent a year as price-earnings multiples tumbled from 22 times in 1961 to 8 times in 1981.

However, those of us lucky enough to have been saving during 1981-2001 received average returns of more than twice that level, 15.2 per cent a year, as price-earnings multiples expanded again to 20 times.

Where will P/E multiples go in the next 20 years?

No one knows, but the fact that P/E ratios now are near the top end of their historic trading range and dividend yields are low does not augur well.

The insurance companies that sell pensions certainly won't be taking any chances; annuities are much more expensive today than they were 10 years ago.

Once you have got your nest egg together, the cashflow that it will produce will be very much less than was the case 10 years ago.

In the 1980s and 90s, New Zealand 90-day bills yielded 5 per cent a year and 9 per cent respectively - after deducting inflation.

Today real yields are barely 2 per cent and are heading south.

Overseas it is the same story. One of the staple investments of US pension funds is 30-year treasury bonds.

In 1983 they yielded more than twice today's levels.

Even with our high local short-term interest rates (relative to those overseas, that is), one struggles to get much above a 5 per cent income before tax and fees when putting together a balanced portfolio which will maintain its value in real terms.

Deduct the 2 or 3 per cent annual cost which is typical of most financial plans and you need capital of about $600,000 to earn an after-tax cash income of $1000 a month.

For many people, uncertain markets increase the attraction of regular pension payments like those from an annuity.

An annuity is a promise by an institution, usually an insurance company or a bank, to make a series of cash payments to an individual for the rest of his or her life.

Annuities represent something of a guessing game for insurance companies, in that they have to earn a return on the money you pay for the annuity in order to fund the payments they make to you.

The insurance company has to guess how much it will earn on the money over the long term, and also guess how long you will live.

The news here is not good either; insurance companies can't afford to guess too high so they are conservative when forecasting returns and - more bad news - we are living longer.

So, faced with the prospect of earning less but living longer, how should investors react? There are three options:

* Save more.

* Take more investment risk.

* Reduce fees.

For many people, the first option is not an option.

There is also a risk that financial advisers will, without consultation, go for the second option.

The rich fee structures which are typical of the local financial planning industry were only sustainable in an era of extraordinary returns, but the industry as a whole may be slow to acknowledge the changed environment.

Taking a higher level of risk may be one way of maintaining the status quo and achieving reasonable returns after fees.

The danger, of course, is the unacceptable level of volatility. Keep a close eye on that asset allocation.

* Brent Sheather is a Whakatane stockbroker and investment adviser.