We invest in the stock market so that we can retire some day. What we expect from the stock market is a return on our investment – a return that includes an “equity premium.” The equity premium appears to be getting smaller.
There are several reasons for this.
Better information, and the tools to analyze the information, has become available.
Meanwhile, the stock market have become more mainstream and has money coming into it from both small and big investors. Modern, and diversified, portfolios have reduced some of the risk of holding stocks, because even if a few companies fail, they won’t take your entire nest egg with them. Rather, the failures average out with the successes to produce a relatively steady rate of return. As defined-benefit pension plans have been replaced with 401(k) plans, people have poured their retirement savings into mutual funds that offer this sort of diversification. The deeper pool of money flowing into equity markets means that equities no longer need to offer a higher yield in order to attract money from bond and other securities markets.
The equity premium’s shrinkage may have another reason. Financial markets have an interesting feature that has undone many a trading strategy: once everyone starts believing something, it often stops being true. If you discover an arbitrage opportunity - otherwise known as a “price anomaly” or “free money” - it will be profitable only as long as few people know about it. Once it is widely known, bidders will rush into the market until the discrepancy is traded away. After that happens, future returns will be lower.
In other words, once everyone believes that the stock market offers high returns for relatively little risk, that notion stops being true. And everyone apparently does believe just that - even after the 2008 crisis, the price-to-earnings ratio of the S&P 500 remains near the top of its average historical range. Paradoxically, the current high price may be supported in part by a belief that the old equity premium still obtains. A survey done by ING Direct in March of this year found that, even after a decade of lousy returns and a spectacular market crash, more than a quarter of Americans expect annual returns in the stock market to average 10 to 20 percent.
Impact on Investors
If the return on equities really has fallen, this decline poses a big problem for the average investor who planned to stick 5 to 10 percent of his or her annual income into stock funds and retire comfortably. At an annual inflation-adjusted growth rate of 8 percent, savings of just 5 percent of your income for 30 years will leave you with a nest egg big enough to replace almost half your income when you retire. Saving 10 percent will make you really comfortable.
But if the return is 2 to 3 percent, you’ll need to save close to 40 percent to replace almost half of your income. And a 2 percent return seems to be a real possibility - in fact, it’s just slightly above the 1.8 percent that Smithers & Co., an asset-allocation consultancy, forecast for U.S. equities over the next decade.
Felix Salmon, a finance blogger, argues that with stocks showing both lackluster prospects and whiplash-inducing price swings, investors might want to get out of the market entirely. That conclusion is tempting: if a quarter of Americans are expecting bubble-grade growth in stock prices, could another correction be in our future?
But if we leave the market, where will we go? When confronted with the erratic performance of the equity market, many people start daydreaming of gold-plated corporate pensions, cushy civil-service jobs, or at least their Social Security benefits. But as it turns out, all of these dreams have drawbacks - and none of them escapes the equity market.
Allison Schrager, an economist who designs investment strategies for retirement accounts, recently wrote on The Economist’s Web site that for private pension funds, the equity premium “is often assumed to be between 5 percent to 8 percent. In my experience, risk managers go silent when asked where exactly this number comes from.” If the future equity premium turns out to be much lower than these fund managers are projecting, the funding gap may be too large for companies to make up - particularly since the gap tends to be largest in recessions, when companies are least able to find the money for extra contributions.
And yet the private plans are in good shape compared with state and local pension funds. For decades, politicians have promised lavish pension benefits in return for the support of the public-sector unions — promises that they, unlike their counterparts in the private sector, did not have to cover by setting aside a reasonably large asset base. Now the bills are coming due, and many funds are disastrously underfunded. The California state pension system, for example, has only 60 percent of the assets needed to pay its obligations through 2042. With a $19 billion budget deficit, the state is unlikely to be able to make up the shortfall unless the stock market starts zooming again.
California is perhaps the most extreme example, because its state tax revenues depend so heavily on the equity premium. When tech stocks boomed, so did incomes in the tech-heavy state; when they crashed, so did tax revenues. Just like private companies, the state systems were caught in a terrible bind - their revenues were squeezed just when they needed to find more money to shore up their pensions. But unlike private plans, these funds have no pension insurer, and while municipalities can negotiate partial payments in bankruptcy, there is no mechanism for state-operated funds to do so.
Not even the federal government can escape the stock market. In the three years after the end of the tech boom, federal tax revenues plummeted from 20 percent of GDP to 16 percent. Many people blame the Bush tax cuts for the entire ensuing budget deficit, but in fact they accounted for less than half of the lost revenue. Most of the change from surplus to deficit came from other factors, most prominently from what the Congressional Budget Office calls “technical” and “economic” change: the government simply collected less revenue during the bust than analysts had anticipated. Wealthy people pay most of the income taxes in America. And their taxable incomes are extremely sensitive to the performance of the stock market - not surprising, considering how many wealthy people either work in finance, or receive compensation in the form of stock options.
For decades, pundits have been warning that a time would come when Social Security would start to become a drain on the federal budget. Now it’s happening. In 2010, for the first time, payouts to retirees and the disabled have exceeded the program’s revenues from payroll taxes. Infusions from the general fund are now needed if the government is to keep mailing checks - a situation that is projected to become a permanent, and growing, problem by 2016.
That means that Social Security, too, is exposed to the performance of the stock market. Unfortunately, unlike the holders of 401(k) accounts, the beneficiaries are not aware of this, which means that they will not, for example, delay retirement until the market recovers. (In fact, Social Security is thought to cause older Americans to retire before they otherwise would.)
Whether Americans know it or not, they have spent decades basing their retirement plans on expectations of big capital gains in their houses and stock portfolios. But no system can completely protect us from the problem of lower asset returns. Schrager suggests that unless we suddenly become willing to save a huge chunk of our income every year, we may need to rethink our retirement plans. “I don’t know if it’s ever going to be realistic that everyone saves enough to spend the last third of their life on vacation,” she says.
[Source: Megan McArdle: "The Great Stock Market Myth"]
Related Information in Prosperity View
- Our Low Savings Rate – Is our Government an Enabler?
- Buy an Annuity and Delay Social Security – GAO
- When the Going Gets Tough the Tough Are Going to Be Ready
- Retirement Benefits, Accounts, Longevity: Delay, Change Lifestyle
- Saving for Retirement Being Hurt by Economy & Attitude
- Saving and Investing – Keeping it Simple
- The Path to Prosperity is Lower Government Spending
- Wealth and Equities: Cash and Global Growth to Propel Stocks
