Our long-term market view - modest returns
Our outlook for global growth, on average, over the next 10 to 15 years is broadly unchanged from 2017 estimates, with developed markets at 1.5% and emerging markets at 4.5%. This translates to constrained, generally modest return expectations across most major asset classes, further impacted by the late stage of the current business cycle.
In an overall portfolio context, the expected return for a simple 60% world equity/40% U.S. aggregate bond portfolio (in our view, a reasonable proxy for the average asset allocation over a typical participant’s life span) has declined to 5.25%, down from 5.50% last year. The stock-bond frontier has shifted in a clock-wise direction—as bonds improve, given an anticipated slow road to normalization, and elevated valuations, typical of the later stage of the business cycle, constrain equity returns (EXHIBIT 1).
Our analysis of the interplay between near-term cyclical factors and more enduring secular trends offers reason for cautious optimism. We see potential for technology-induced productivity improvements to help end a prolonged series of downgrades to trend growth. Nevertheless, investors can still expect to face a historically low return environment over the next decade.
Our 2018 Long-Term Capital Market Assumptions call for another slight decline in returns for a simple 60/40 stock/bond portfolio
EXHIBIT 1: USD STOCK-BOND FRONTIERS AND 60/40 PORTFOLIOS BASED ON 2018 VS. 2017 LTCMAs FOR RISK AND RETURN (%)
Source: J.P. Morgan Asset Management; estimates as of September 30, 2016 and September 30, 2017
What plan sponsors can do
The long-term outlook for capital markets rarely changes dramatically in the course of a single year and plan sponsors have little influence over its course. But, as we have emphasized many times, there are three concrete steps plan sponsors can take to help improve participants’ retirement outcomes—appropriate in a low-return world—and across all market environments.
Encourage greater savings
Participants need to save more and start early. Our latest long-term economic growth and market return assumptions, combined with longer life expectancy, validate participants’ concerns about the possibility of outliving their retirement savings. Saving more is the most obvious and effective way to improve retirement outcomes.
We believe the best approach to encouraging saving is to actively place participants on a solid savings path through plan design options such as automatic enrollment and automatic contribution escalation. While some plan sponsors are concerned about push back on features that might appear to diminish participants’ decision-making control, our research suggests that most participants are in favor of, or at least neutral toward, these programs.1 What’s more, our 2017 plan sponsor research indicates that a majority of DC plans have implemented automatic enrollment while half automatically escalate participant contributions.2
Make portfolio diversification easier
Return estimates for a simple 60%/40% stock/bond portfolio are, once again, down relative to the prior year’s assumptions. But, as seen in EXHIBIT 1, there are a number of asset classes clustering close to, and even lying above the stock/bond frontier, implying opportunity for diversification and potential return enhancement. For example, our outlook for a gradually weakening U.S. dollar over the longer term suggests potential benefits from international diversification for U.S. investors. Credit remains the bright spot in fixed income, and although the current credit cycle is rather mature, our long-term projections of credit spreads, defaults and recovery rates continue to imply a reasonable return uplift above government bonds and argue for diversification beyond a U.S. aggregate bond portfolio.
The goal, of course, is not simply to offer a broader range of investment options within the core menu; that would leave the complex task of asset allocation to plan participants. In fact, our research suggests that only about one-third of participants are confident in their ability to choose the right investment options from their plan lineups. A similarly small percentage are confident that they can appropriately adjust the allocation of their portfolios as they approach retirement.3
In our view, the best way to ensure participants realize the true advantages of diversification all along the road to retirement is through professionally managed portfolio strategies, such as target date funds (TDFs). Of course, that assumes the TDF itself is well-diversified, constructed by skilled asset allocation professionals who understand how participant behavior and investment needs vary over the life cycle and rely on a consistently derived set of long-term asset class return, risk and correlation estimates to inform portfolio construction and management. When such TDFs are chosen as qualified default investment alternatives (QDIAs), the impact may be even greater. In that case, assets and/or contributions of new participants automatically enrolled in the plan or of existing participants who are re-enrolled,4 are defaulted into the plan’s chosen TDF (unless, in either case, the participant opts out). Nearly three-quarters of plans with a qualified default investment alternative have chosen TDFs as their QDIA.5
Employ active management
Keep in mind that there are two components of return: the portion due to the market itself (beta) and the portion resulting from active manager skill (alpha). Our Long-Term Capital Market Assumptions, by design, do not reflect returns to active management; they are estimates of index-based (or beta) returns, intended to inform strategic allocation or policy-level decisions over a 10- to 15-year investment horizon.
With a lower outlook for beta returns across most asset classes, alpha becomes an even more critical component for achieving required returns. Skilled professional investors can generate alpha through adept security selection and/or tactical asset allocation—opportunistically shifting assets across sectors, asset classes and regions as attractive opportunities present themselves. For example, insights into tangible investment opportunities associated with technological change (as discussed in our 2018 Long-Term Capital Market Assumptions) and the ability to tactically position portfolios through the late-cycle challenges ahead present opportunities for alpha generation. And given the low correlation between the alpha and beta components of return, the active component can also help to diversify portfolio risk.
Automate, “uncomplicate,” activateUltimately, plan participants are responsible for saving enough to support their retirement goals—but too often, lack of time, interest and investment knowledge, along with inertia, holds them back. Plan sponsors can fortify their plans by adopting automatic features, “uncomplicating” the diversification process through TDFs and providing active management opportunities to help enhance returns. Setting participants on this type of solid saving and investing path is one of the surest ways to help them achieve a financially secure retirement.
Implications for plan sponsors and their advisors/consultants
More than ever, a secure retirement requires saving adequately and investing wisely. We encourage plan sponsors who have not already done so to work with their plan advisors/consultants and evaluate the feasibility of the following actions for their plans:
- Adopt automatic enrollment and automatic contribution escalation to encourage greater saving.
- Evaluate whether a re-enrollment may be appropriate for the plan’s participants.
- Consider well-diversified target date funds as the plan’s qualified default investment alternative to help ensure that participant portfolios are broadly and effectively allocated —both initially and as participants approach retirement.
- Select professionally managed target date fund strategies with the potential to provide enhanced returns through both skilled security selection and tactical asset allocation.
It’s true—the outlook for long-term capital market returns has dimmed. But, these plan design and investment options can strengthen plans and help more participants reach their retirement goals.