With low returns likely over the next 10 years, pension plans and other financial institutions are not expected to achieve their target returns, suggests a new report from BNY Mellon.
A new report from New York-based BNY Mellon Investment Strategy and Solutions Group (ISSG) and BNY Mellon Wealth Management, projects an expected return of 7% for U.S. large cap stocks and similar risk-adjusted returns for U.S. small and midcap stocks annually over the 10-year period, driven by real earnings growth of 2% per year, a dividend yield of 2.25%, and inflation of 2.5%. ISSG noted that the 2% earnings growth projection is significantly below the near-term consensus of 6% annually.
In fixed income, ISSG sees real cash rates rising to approximately 1% annually in the U.S. in 10 years. ISSG said with inflation at 2.5%, it expects the 10-year Treasury yield to be 3.5%, causing long-term Treasuries to provide a negative return over the 10-year period.
Expected returns for alternatives depend heavily on the underlying asset class, with a range of 3% to over 11% for the category, ISSG said.
“Based on our research and analysis, we are projecting extremely low fixed income returns and single-digit equities returns over the period, which will make it challenging for institutions to reach their target returns,” said Jeffrey Saef, managing director for BNY Mellon and head of ISSG. “If institutions remain intent on aiming for combined 8% returns, they may need to seriously consider taking on more risk in their portfolios.”
The report notes that interest rate increases could adversely affect returns of fixed income assets held by pension plan sponsors, many of which are underfunded. However, these same interest rate increases would also reduce plan liabilities, which might result in a net increase in funding levels.
ISSG said that concerned plan sponsors need to consider whether they need to add exposure to equities. In addition, they could consider shortening the duration of their fixed income holdings, the report said.
“High net worth individuals, foundations and endowments aiming to preserve purchasing power also should consider revisiting their fixed income allocation over the 10-year period,” said Leo Grohowski, chief investment officer for BNY Mellon Wealth Management.