It is absurd, and that's why the IFRS and US government forced corporation pension funds to use discount rates that match high grade corporate bond yield curves (which are no where near 7%).
I mean, the comparison should be against the stock market, not high grade corporate bonds.
Stick the money in the s&p 500 and it will easily get 7%. (The real number over the last 100 years is 9.7%). Having the number br 2.7% lower then that is a fair compromise to take into account risk.
>> I mean, the comparison should be against the stock market, not high grade corporate bonds.
A pension fund has ongoing annual liabilities, so they cannot invest a majority of their assets into the stock market because they cannot afford to suddenly lose 40% of their assets. That is why they are usually spread across asset classes and have a lot in corporate debt (which are providing more than US Gov debt, but have higher returns are almost never suddenly lose 30% or 40% value across the board.)
What is your source for 9.7%? I suspect it’s subject to survivorship bias.
There’s plenty of research on choosing discount rates for defined benefit pensions and annuities, and many papers to read. And there are myriad reasons you can’t just stick the money for a pension in the s&p 500, but suffice to say, everhone in finance sticks to the IFRS numbers and knows US GAAP is garbage.
My source is the S&P 500, which has been around for a hundred years.
You can pick the DOW if you like, as it has similar returns over the last hundred years.
Although, FYI, the 9.7% number I was using was not inflation adjusted. Perhaps that 7% number was inflation adjusted? That would make sense as the s&p inflation adjusted number comes out to be 7% almost exactly.
This is not survivorship bias, as the way investing in the s&p 500 works is that it is a moving list of the top 500 companies market cap.
IE, if a company goes down in price, and drops out of the top 500 companies, then so would your investment in it. And total returns take this into account.
It is perfectly possible to simply invest in the market, and recieve market returns, if you are also willing to accept market risks.
The stuff you are talking about, regarding risks, only matters to people who care about short term returns, not people who care about long term returns.
And a pension fund, which has a time horizon of decades, seems like the very best example of a fund that would not care the slightly about short term risk, and can instead optimize for long term returns.
Pension funds need to pay out all the time, in good times and bad, so they also have a short term component to worry about it. And they do invest in index funds, but going all in into sp500 isn’t the same as diversifying. Here are some good responses:
Pension funds also have money flowing in. They invest more money in down markets than good ones because they need to ‘catch up’ in bad markets and can scale back in good ones. The risk is the company failing to keep up in a bad year.
Diversification is also a relative term. Compared to owning a single stock the sp500 is more diversified.
But 130% would be absurd in that it can't happen, but 7% is within the realm of possibility. So, unacceptably optimistic or unlikely etc sure but the bar for absurd is higher than just unusual.
I’ve seen pension funds with an discount rate sensitive causinf a 1% change in discount rate can have a ~20% effect on liability. Being off even a few hundred basis points results in huge numbers. There’s a reason you don’t see annuities equal to taxpayer funded defined pensions even offered for sale.
its little-stated due to the massive fiscal and political implications but there's a belief among some of the better investment professionals out there that the past decade of 1) low baseline interest rates 2) large run up in stock multiples, 3) proliferation of index funds ... will depress long-run stock total returns into the 4-6% range for many decades.
