The implications of lower returns

Investment returns are set to be lower during the next two decades, as illustrated in a previous news on altii - with severe consequences for asset owners and managers. McKinsey outlines those for defined-benefit public-employee pension funds, private-pension funds and traditional-asset managers in their article “Look out below: Why returns are headed lower, and what to do about it”.

Despite an increased allocation to equities, US public-employee pension plans face funding gaps. Within the last three decades, their allocation into debt has fallen from 75 percent to 27 percent. Still, returns are not able to match promised pensions in 90 percent of state and local employee retirement funds, leaving a funding gap of approximately $1.2 trillion. An analysis pursued in 2014 shows that pension funds still expect median future returns of 7.65 percent, which is above the level expected by McKinsey even in a more optimistic growth recovery scenario. With lower returns, the funding gap of US public pension plans could widen by $1 to $2 trillion in a slow-growth scenario or about $0.5 trillion in the growth-recovery scenario.

Private pensions plans have experienced the effect of lower interest rates already, which have increased the present value of their pension liabilities by about 44 percent between 2007 and 2014. Assets have, however, only grown by 12 percent in the same period, identified McKinsey. Despite improving funding ratios since the financial crisis, the funding gap still amounts to about $300 billion. However, with expected returns of 7 percent in the US and 5.7 percent in the UK (both nominal), returns are in line with a growth-recovery scenario but higher than in the slow-growth case. 

Asset managers do not just have to worry about lower returns but also about a shift from investor demand from active to passive products. McKinsey believes that this trend could accelerate due to lower returns as investors prefer products with lower charges. Therefore, asset managers must rethink their asset-gathering and investment strategies. One option would be to increase the allocation to alternatives assets such as infrastructure or hedge funds. Another one would, paradoxically, be to increase active management capabilities. While only a few managers can outperform the markets consistently, those will be in even greater demand during the next 20 years.