Pension Consulting Alliance, Inc. | | 2016 Ten-Year Capital Market Assumptions
page
2016
TEN-YEAR CAPITAL MARKET
ASSUMPTIONS
PENSION CONSULTING ALLIANCE, INC.
TABLE OF CONTENTS
2016 vs. 2015 Assumptions
2
Summary & Highlights
2
Creating Arithmetic Returns
3
Creating Geometric Returns
3
Pension Consulting Alliance, Inc. | | 2016 Ten-Year Capital Market Assumptions
page
2
ASSET CLASSIFICATION
2015
COMPOUND
EXPECTED
RETURN
2016
COMPOUND
EXPECTED
RETURN
CHANGE
from
2015 to 2016
Cash
2.00
2.00
0.00
Treasury Inflation Protected Securities
3.00
3.00
0.00
US Treasuries Only Fixed Income
2.00
1.90
-0.10
US Core Fixed Income
2.65
2.90
0.25
US Credit Fixed Income
3.30
3.85
0.55
Core Real Estate
5.60
5.10
-0.50
Domestic Equity
6.90
6.90
0.00
International Equity
7.20
7.45
0.25
Global Equity
7.20
7.45
0.25
Hedged International Equity
7.40
7.65
0.25
Private Equity/Venture Capital
8.80
9.05
0.25
Inflation
2.50
2.25
-0.25
2016 vs. 2015 ASSUMPTIONS
A comparison of PCA’s 2016 10-year compound asset class total return assumptions versus those in 2015.
1. We use a building block method for estimating arithmetic returns as detailed on page 3:
(Inflation) + (Real Risk Free Rate of Cash) + (Premium over Real Risk Free Rate)
2. All risky-asset class return expectations (all asset classes that are not cash) are built as risk premiums
over cash. Our expectations for long-term cash returns are 25 basis points below inflation at 2.00%.
3. Compound expected return estimates are the result of first estimating arithmetic average asset class
returns and volatilities, which are then converted to geometric return estimates.
4. We project cash to return less than inflation over the next 10-year period.
5. Based on these assumptions, an allocation of 60% global public equities, 20% core bonds, 10% core
real estate, and 10% private equity, has an expected long-term compound return of approximately 6.9%.
6. Mean-variance analysis is a reasonable starting point for portfolio analysis; other approaches are
warranted.
Pension Consulting Alliance, Inc. | | 2016 Ten-Year Capital Market Assumptions
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3
CREATING ARITHMETIC RETURNS
CREATING GEOMETRIC RETURNS
ASSET CLASS
INFLATION
+
REAL
RISK-FREE RATE
+
RISK
PREMIUM
=
ARITHMETIC
RETURN
US Treasuries Only Fixed Income
2.25
+
-0.25
+
0.00
=
2.00
US Core Fixed Income
1.00
=
3.00
US Credit Fixed Income
2.00
=
4.00
Core Real Estate
3.50
=
5.50
Domestic Equity
6.50
=
8.50
International Equity
7.50
=
9.50
Global Equity
7.10
=
9.10
Hedged International Equity
7.40
=
9.40
Alt. Inv./Private Equity
10.10
=
12.10
(ARITHMETIC RETURN ESTIMATE) – (VOLATILITY PENALTY) = (GEOMETRIC RETURN ESTIMATE)
ASSET CLASSIFICATION
ARITHMETIC
RETURN
ESTIMATE
VOLATILITY
PENALTY
GEOMETRIC
RETURN
ESTIMATE
EXPECTED
STANDARD
DEVIATION
Cash
2.00
n/a
2.00
1.00
Treasury Infl. Protected Securities
3.15
-0.15
3.00
6.00
US Treasuries Only Fixed Income
2.00
-0.10
1.90
5.00
US Core Fixed Income
3.00
-0.10
2.90
4.00
US Credit Fixed Income
4.00
-0.15
3.85
6.00
Core Real Estate
5.50
-0.40
5.10
9.00
Domestic Equity
8.50
-1.60
6.90
18.50
International Equity
9.50
-2.05
7.45
21.00
Global Equity*
9.10
-1.65
7.45
19.00
Hedged International Equity
9.40
-1.75
7.65
19.50
Private Capital/Venture Capital
12.10
-3.05
9.05
26.00
Inflation
2.25
n/a
2.25
1.00
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Sum
mary
of
Inv
est
ment
Class As
sumptions
Expected Arithm etic A v erage Nom inal A nn ual Retu rn Expected G eom etric 1 Com po un d Nom inal A nn ual Retu rn Expected Risk of Nom inal Retu rns (A nn l. SD) Cas h T IPS T S Y Co re F x d Cre d it Rea lEs t USEq Intl E q Glb lEq HIn tl E q P ri v E q Cas h 2.00 2.00 1.00 Tr eas ury Infl . Protec ted S ec uriti es 3.15 3.00 6.00 0.20 US Treasuri es O nl y Fixed Inc ome 2.00 1.90 5.00 0.30 0.50US Core Fixed Inc
ome 3.00 2.90 4.00 0.25 0.60 0.30 US Credi t Fixed Inc ome 4.00 3.85 6.00 0.00 0.65 0.00 0.75 Core Real E state 5.50 5.10 9.00 0.30 0.00 0.00 0.00 0.00 Domes tic Equ ity 8.50 6.90 18.50 0.00 0.00 -0.25 0.20 0.40 0.40 Internati onal Equ ity 9.50 7.45 21.00 0.00 0.00 -0.35 0.10 0.20 0.30 0.80 G lobal Equ ity 2 9.10 7.45 19.00 0.00 0.00 -0.30 0.15 0.30 0.35 0.90 0.90 Hedged Internati onal Eq ui ty 9. 40 7.65 19.50 0.00 0.00 -0.30 0.10 0.30 0.35 0.85 0.90 0.90 Pri vate E qui ty /Ven ture Capi tal 12.10 9.05 26.00 0.00 0.00 -0.30 0.00 0.30 0.30 0.85 0.80 0.80 0.80 Infl ati on 2.25 2.25 1.00 0.50 0.45 -0.10 0.00 0.10 0.35 0.20 0.20 0.20 0.20 0.10
Sig
ni
fica
nt
Changes
from
Las
t Yea
r’s
Ja
nu
ar
y
2015
Ten
-Ye
ar
A
ss
umpti
on
s
Update
Infla
tion
ex
pe
ctatio
ns de
cli
ne
d w
ith
lo
w
er
marke
t bre
ake
ven
infla
tion
le
vel
s,
lo
w
er rea
lized
infla
tion
, and
lo
w
er
con
sen
sus
pro
je
ct
ions
.
Co
re fix
ed
inco
me e
xpe
cted
return
s ha
ve in
crea
sed
du
e to a y
ea
r-ove
r-y
ea
r incre
ase
in y
ie
ld
s.
U.S.
eq
ui
ty
ex
pe
ctatio
ns re
mai
n u
nch
an
ge
d, f
ol
lo
w
in
g a
y
ea
r of
low
retu
rns a
nd
little ch
an
ge
in va
lu
atio
ns.
Non
-U.S.
eq
ui
ty
ex
pe
ctatio
ns h
ave
risen
, foll
ow
in
g a
y
ea
r of
ne
ga
tive
retu
rns
, le
ad
in
g to imp
rove
d va
lu
atio
ns o
utsid
e o
f the
U.S.
In
di
ce
s Us
ed i
n
Mod
elin
g
A
ss
et Cla
ss
A
ss
umpti
on
s
A
ss
et Cla
ss
In
dex
Cas h Ci tigroup 3 month US Tr eas ury Bi ll Index TIPS Barc lay s Capi tal TIPS, si mul ated TIPS s eries per Bridg ew ater US Treasuri es O nl y Fixed Inc ome Barc lay s Capi tal US Treasu ries IndexUS Core Fixed Inc
ome Barc lay s Capi tal Uni versal , Barc lay s Capi tal Agg regate Index , Barc lay s Capi tal G /C Index, Barcl ay s Capi tal Intermedi
ate Govt. Ind
ex , Barc lay s Capi tal Corp/Cr edi t Index US Credi t Fixed Inc ome Barc lay s Capi tal US Uni versal Spread 1 -10 Index , Barc lay s Capi tal Corp/Cr edi t Index Core Real E state
NCREIF NPI Ind
ex , Pri or Indic es Domes tic Equ ity Rus sel l 3000 Inde x, S& P 50 0 Index Internati onal Equ ity MS CI/Barra ACW I ex -US Ind ex , MS C I/Barra EA FE Index G lobal Equ ity MS CI/Barra ACW I Index Hedged Intl . E qui ty Hedged MS CI/Barra EA FE Index , MS CI/Barra ACW I ex -US Ind ex , MS
CI/Barra EMF Index
Pri vate E qui ty Pri or Brins on V enture Capi tal Index, VCJ Pos t Ven ture Capi tal Index 1 G eometri c retur ns are comparabl e to ac tuarial as sumpti on rates for pens ion funds . 2 The co mpoun d return esti mate o f G lobal Equ ity is not a s im pl e av erage betw een Dom es tic Equ ity and Internati onal Equ ity c ompou nd returns. Inte rnation al Equ ity and Dom es tic Equ ity are not perfec tly c orr el ated. Therefore , a Global Equ ity portfol io has low er vol ati lity than the w ei ghted av erage of c ompon ent v ol ati liti es . Low er vol ati lity resul ts in hi gher co mpoun d returns.
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Expecte
d I
nfla
tion,
Av
erage Annual Risk
Free Rat
es & Annual
Risk P
remi
ums
for Vari
ous
Classe
s
-
%
Categ ory Expectatio n – A nn ual % Com men ts Inf latio n 2. 25 Long -term infl ati on ex pec tati ons hav e been revi sed dow nw ard (25 bps ) from las t year. The TIPS breake ven infl ati on rate, one important data poi nt indi cati ve of equi librium pric ing of infl ati on ex pec tati ons , w as 1. 5% as of Dec ember 201 5. The real rate of 10 -y ear TIPS inc reased in 201 5 to approx imatel y 0. 75 % as of year end . Real iz ed infl ati on has al so been very l ow , <1. 0% on an annual iz ed bas is after s eas onal adj us tment. Thi s mark s the first time si nc e the 1960s that reali zed infl ati on ha s been bel ow 2% for four c ons ec uti ve cal endar years. The Uni versi ty of Mi chi gan Surv ey of 5-to -10 year annual infl ati on ex pec tati ons reg is tered at 2. 6% as of Dec ember 201 5 dec lini ng 20bps from the prior year . Comm odi ty pric es (br oadl y) conti nued to fal l during the years , w ith oi l pric es fal ling bel ow $ 30 after year end. The U.S. unemp loy ment rate has c onti nued to dec line (dr oppi ng to 5.0 % in Dec ember 201 5 from 5.6 % in Dec ember 201 4). Final ly , the Fed rais ed thei r target short -term in terst rate by 25 bas is poi nts at thei r Dec ember meeti ng, a mov e not w el l recei ved by c omm odi ty and equi ty mark ets in early 2016, i ndi cati ng dow nw ard press ure on grow th and infl ati on expectati ons . Real Risk -Free Rates Short -term (Cash) -0. 25 Federal Res erve rais ed short -term lendi ng rates in Dec ember to approx imatel y 35bps after floati ng betw een 0.05% and 0.15% during the year. This lev el is sti ll muc h low er than long -term infl ati on ex pec tati ons and recent reali zed infl ati on. Thus, the Fed’s c urr ent short -term rates es tabl is h real le ndi ng rates that are si gni fic antl y negati ve . Expect ati ons are for thes e low s hort -term lendi ng rates (thus negati ve real rates) to ris e sl ow ly , leadi ng to nega tiv e real rates ov er the i nv es tment h oriz on on av erage. Longer -term (10 -y ear T IPS y iel d) 0. 75 The ex pec ted long -term real yi el d is projec ted as the curr ent 10 -y ear TIPS real yi el d. As of Dec ember 201 5, the 10 -Y ear T IPS real y iel d w as approx imatel y 0. 75 %, inc reasi ng from 0.50 % in Dec ember 201 4. Risk P remiums o v er S ho rt -term Risk -free Rate: US Treasuri es O nl y Fixed Inc omeUS Core Fixed Inc
ome US Credi t Fixed Inc ome 0.00 1.00 2.00 As of Dec ember 2015 , the yi el d-to -maturi ty (Y TM) on the U.S. Tr eas ury Index wa s 1. 7%. The YTM on the 10 -year treasury w as 2 .3 % and fel l to bel ow 1.9% after year end 2015 . The YTM on the Barc lay s Capi tal U.S. Uni ver sal as of Dec ember 201 5 w as 3.2 %. The YTM on the U.S. Uni versal Spread 1-to -10 year Index w as 4.25 %. 201 5 saw c redit spreads w iden year -ov er -y ear, mov ing abov e long -term av erage lev el s. Interest rates on short -term U.S. Tr eas ury debt inc reased w hi le long term rates fel l, fl atteni ng the yi el d curve. The Fed rais ed interest rates in 2015 but ex pec tati ons are for a sl ow ris e ov er the inv es tment h oriz on . Curr ent expected retur ns repr es ent no l ong -term s pread c ompres si on and no mov ement in longer -term interest rates. Core Real E state 3. 50 As sumes a mi x of priv ate core real es tate and an al loc ati on of 15% to publ ic real es tate sec uriti es . Es timate as sumes s tabl e i nterest rates, and a s tabl e to ris ing c ap rate l ev el , reverti ng tow ard s hi storic al av erages . Domes tic Equ ity Internati onal Equ ity G lobal Equ ity 6.50 7.50 7.10 O n av erage ov er the pas t 7 years, the reali zed U.S. equi ty ris k premi um has been w el l abov e hi storic al av erage s. After a year of muted reali zed retur ns , w e ex pec t s ome conti nued mean revers ion to oc cur ov er the next sev eral years in thi s premi um . Fundamental ex pec tati ons are in line w ith thes e ex pec tati ons . Curr ent U.S. val uati ons are w el l abov e hi stor ic al av erages and mos tly unc hanged from a year ago . W hi le, the non -U.S. equi ty v al uati ons are bel ow hi storic al av erages . For l onger -term pl anni ng purpos es , w e as sume non -U.S. equi ties to del iv er sl ightl y hi gher retur ns . Hedged Internati onal Eq ui ty 7. 40 Internati onal equi ty premi um les s fric tional c os t of hedgi ng. Note that no long -term i mpac t from curr enc y mov ements is as sumed o n U.S. Dol lar -bas ed i nternati onal equi ty retur ns . Al ternativ e Inv es tments /Pri vate E qui ty 10.10 Expect ed l ong -term i lliqui di ty premi um ov er glob al publ ic equi ty of 3.0%.
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Not
es:
PCA dev el oped its av erage annual retur n premi ums and standard dev iati on es timates us ing a combi nati on of approac hes . Firs t, for maj or as set cl as ses w ith an appropriate amoun t of hi story , PCA s tudi ed hi storic al ti me series ov er both one -y ear and fiv e-year hol di ng periods to unc ov er any s pec ifi c trends in the time series data. For ex ampl e, domes tic s toc k retur n premi ums ex hi bi t c yc lic al behav ior, w ith eac h ful l c yc le las ting approx imatel y 40 -50 years. Stati sti cal proced ures w ere us ed to identi fy s uc h trends and ex trapola te thes e trends 10 -15 years forw ard. Sec ond, PCA ex ami ned fundam ental v ariabl es underly ing sev eral maj or as set cl as ses and compute d ex pec tati ons bas ed on cons ens us v iew s of thes e variab les . PCA al so revi ew ed outl ook opi ni ons from a handful of leadi ng inv es tment bank s and inv es tment adv is ory fi rms . PCA c ompi led thes e opi ni ons to dev el op cons ens us ex pec tati ons for the maj or as set cl as ses . PCA then us ed thes e cons ens us ex pec tati ons as re ference c hec ks agai ns t i ts ow n ex pec tati ons . Final ly , PCA profess ional s di sc us sed and debated as set ex pec tati ons internal ly unti l a c ons ens us v iew dev el oped. In recogn iz ing that as set cl as s ris ks are not al w ay s stabl e, PCA al so ex ami ned ris k trends uti liz ing si mi lar stati sti cal proced ures. PCA al so cal cul ated ris ks w ei ghti ng more recent periods heav ier than earli er periods . In certain ins tanc es , w ei ghted standard dev iati ons di ffered materi al ly from bas ic s tandard dev iati ons . In thes e cas es , PCA uti liz ed w ei ghted standard dev iati ons as a bas e line for anal
ys is . In recogn iz ing that corr el ati ons are al so not al w ay s stabl e, PCA anal yz ed the curr ent behav ior of the corr el ati ons among maj or pai rs of as set cl as ses . In anal yz ing the corr el ati on trends among p ai rs of as sets , w e foc us ed on corr el ati on trends ac ross non -ov erlappi ng fiv e-year hol di ng periods . Us ing stati sti cal proced ures hi ghl ighted abov e, w e ex trapola ted the trends of thes e corr el ati ons into the future to gai n a sens e of thei r lev el and di recti on. For c orr el ati on pai rs contai ni ng short annual retur n hi stories , w e anal yz ed corr el ati ons of annual retur ns . Si mi lar to anal yz ing ris ks , w e al so appl ied a dec ay fac tor to retur n hi story and c al cul ated w ei ghted c orr el ati ons w here appro priate. The inv es tment cl as s ris k premi a es timated for cl as ses that cons is t of publ ic ly traded sec uriti es are mark et “beta” retur ns , and do not as sume retur ns to ac tiv e manag ement, nor ac tiv e mana geme nt fee s. The ris k premi a for inv es tment cl as ses that , by defi ni tion , are ac tiv el y mana ged (e.g. priv ate real es tate, hedge fund of funds , priv ate equi ty ), hav e been dev el oped “net ” of c us tomary inv es tment m anagem ent fees , w hi ch are intrins ic to the indi ces from w hi ch the premi a w ere dev el oped. Giv en the compl ex iti es as soc ia ted w ith dev el opi ng capi tal mark et ex pec tati ons , w e adv is e us ers of the abov e informati on to rely on judgme nt as w el l as opti mi zati on approac hes in setti ng strategic al loc ati ons to any s et of inv es tment cl as ses . Pl eas e note that al l i nformati on show n is b as ed on qual itati ve and quanti tati ve anal ys es . Excl us iv e reli anc e on the abov e is not adv is ed. This informati on is not intended as a recom menda tion to inv es t i n any partic ul ar as set cl as s or as a promi se of futu re performanc e. Referenc es to future retur ns for ei ther as set al loc ati on s trategie s or ass et c las ses
are not promi
ses or eve n es timates of ac tual retur ns a c lient portfol io may ac hi ev e. As sumpti ons , opi ni ons and es timates are provi ded for illus trativ e purpos es onl y. They s houl d not be reli ed upon as recom menda tions to inv es t i n or av oi d certain inv es tments . For ec as ts of financ ial mark et trends that are bas ed on curr ent mark et condi tions c ons titute our judgme nt and are subj ec t to change. W e be liev e the informati on provi ded here is reli abl e, but do not w arr ant i ts ac curacy or com pl etenes s. This materi al has
been prepared for info
rmati on purpos es onl y.
