Money: Actuaries dole out a dose of realism for the future

By BRENT SHEATHER

Over the past 20 years, returns from the US stockmarket, as measured by Morgan Stanley Capital International and in US dollar terms have averaged 17.9 per cent a year.

Over the past 10 years the rate of return was 18.3 per cent a year. This compares with a longer-term average, 1926 to 1999, of 11.2 per cent a year.

Much of the outstanding recent performance has arisen not as a result of higher profits but from the willingness of investors to pay higher prices, in terms of multiples of a company's earnings. In other words, shares have become more expensive.

According to Standard & Poor's the average price-earnings ratio of companies in the S&P500 index in December 1999 was 30 times. In 1980 it was 15.4 times.

In other words, we're looking at much lower returns from shares in particular, but also property and bonds, in the future.

The high probability of lower returns in the future has got the usually staid and solemn Institute of Actuaries in Britain very excited, so much so it recently formed a working party to consider the implications of a prolonged period of low inflation.

Its conclusions are sobering and should be compulsory reading for all those involved in the savings industry - especially those poor devils just starting to save for their retirement.

The actuaries believe they need to provide leadership in restraining unrealistic expectations as regards future returns from investment markets generally.

Over the long term, the return from equity investments should be equal to the dividend yield plus GDP growth. In the context of the British financial markets, which are likely to be pretty indicative of global markets, the actuaries believe long-term returns will be as follows: equities 7 per cent a year and bonds 5 per cent a year.

For a typical NZ balanced unit trust or pension fund, they are saying we should expect pre-tax, pre-fee nominal returns of just 6.2 per cent a year or, less tax, inflation and fees, around 1 per cent a year.

In contrast, some local luminaries assume 7 per cent a year after tax, fees and inflation - seven times what the actuaries predict. Readers just starting to contribute to a pension should sit down: the paper produced by the working party, published in March, concluded that an individual who had paid 10 per cent of his salary for 30 years into a defined contribution pension and retired today would receive an annuity equivalent to 70 per cent of his final salary.

Those retiring in 2010 would get 50 per cent, and people retiring in 2020 would get 30 per cent of their final salary.

These are worrying statistics even for that small group of retirees who do manage to put aside 10 per cent of their salary for 30 years. The average wage or salary in NZ is $33,000 a year; 30 per cent of this is $190 a week. It costs the average retired couple around $420 a week to live.

The actuaries conclude that the answer to the problem is that we should be putting more than 10 per cent of our salaries away for our retirement - which is obvious enough. However, this just may not be practical for some individuals.

There are a few other strategies we can employ, especially those people with 20 or more years before retirement.

Among them are:

Increase the equity and property component of the portfolio. For example, a 20/20/60 portfolio should generate a pre-tax, pre-fee, nominal return of 6.6 per cent a year as against the 6.2 per cent a year forecast.

Minimise annual fees - a 2 per cent a year fee takes one-third of annual returns, a 0.5 per cent fee just 8 per cent.

Avoid capital gains tax.

In the US and Britain, institutional investors are allocating increased resources to venture capital funds in the hope of achieving higher returns.

A recent report by Merrill Lynch Mercury Asset Management advocates a 10 per cent weighting in venture-cap and concludes that the sector's reputation for volatility is undeserved.

The British Government has recently urged pension funds to raise their allocations to the venture capital sector.

However, even a 10 per cent weighting in venture cap is unlikely to add more than 0.5 per cent a year to the long-term returns.

In the US, gearing up one's portfolio through borrowing has long been a popular get rich quicker strategy. The problem is that in an environment of 7 per cent a year equity return, the cost of funding could be prohibitive.

The market for reverse mortgages needs to be developed, possibly with Government involvement.

Spare a thought too for those companies providing a defined benefit pension - a pension which guarantees, for example, a pension equivalent to your last year's salary.

Over the past 10 years or so some companies in New Zealand and overseas have had to contribute very little to their employees' subsidised super schemes because the returns have been much higher than actuaries had forecast.

It is clear Government has a role to play here by encouraging personal retirement planning through tax breaks such as in Australia, the US and Britain.

The trick will be to foster an environment which encourages saving while ensuring that those instruments which qualify for the tax incentives are broad enough to promote a far higher level of competition than the present farcical environment in which virtually every equity unit trust has a 1.5 per cent-a-year management fee.