How history has contributed to market excess.

September 8, 2017

By now, you are familiar with the phrase that must accompany any advertisement pertaining to investments, that “past performance is not an indicator of future returns”. This is not just a necessary disclaimer, but one of the golden rules of investing. Unfortunately, much of the collective behaviour of hunting for yield stems from individuals and the industry still looking backwards at historical returns as a guide for current strategies.

Nowhere is this more prevalent than in the pension industry. Under current rules in Canada, an Individual Pension Plan (IPP), which is a defined benefit pension, must generate an average annual return of 7.5%. This is determined every three years from an actuarial review. If it does not, then that person’s company must make up the difference. In the US, public defined pensions have also followed a required annual return rule of close to 7.5%.  Unless a pension fund manager wants to run continual deficits, it must shoot for this goal, even if it means taking on more risk to get there.

Let’s be clear. The ‘requirement’ to make 7.5% per year stems back to a time when such returns were ‘easier’ to get. And this has nothing to do with whether equity markets did better in the past than today, although we have certainly been through a 30+ year period of exceptional gains. It comes down to where interest rates were when these return guidelines were adopted. In other words, a lot higher than where they are today. Back in the 1980s, the 20-year average for the US 10yr bond yield was above 8%. Today it is under 4%. Put another way, thirty years ago a pension fund manager didn’t really have to depend on the equity market for anything to achieve a 7.5% return. Today, stocks carry more than half of the annual burden.



Of course, interest rates and yields may rise in the future, but most analysts will tell you we are stuck in a 2-3% world for the foreseeable future. And it is not just the equity market where fund managers have had to go to in search of return. There has been a massive shift towards high yield or junk bonds, as well as alternative investments like hedge funds. Recently, the high yield market has done well, not necessarily because of stellar fundamentals, but because of the flood of capital into these investments. Tajikstan, a country with annual GDP of US$7 billion (half coming from migrant remittances) came to market for the first time this week with a 7.125% bond and was over-subscribed.


The logical escape from this is to lower the required return on fund assets and there are some pensions in the US that are starting to do this, in response to the new interest rate reality. The problem is that there is no free lunch in the pension world. If returns are to be lower, then benefits will have to be lower as well in order to maintain the solvency of a pension. All other things being equal, this will mean that an individual will have to either (A) increase their own personal retirement savings, work longer or scale back their retirement lifestyle expectations. The latter is hard as everyone has been brought up on the same artificial return expectations for years and therefore find it difficult to accept a lifestyle that is sub-standard to what their parents may have had. This problem is mitigated to some degree by the fact that defined benefit pensions are much less prevalent than they were thirty years ago. The shift by companies and governments in this country towards defined contribution pension plans eliminates the reliance on arbitrarily high return assumptions.


That doesn’t necessarily mean that individuals are scaling back their own assumptions. This is why we have adopted the practice in our own financial planning of setting lower return forecasts—3% for conservative portfolios and 4% for those with more than half allocated to stocks. Coupled with assumptions of higher than current inflation and realistic spending (not budgeted spending), plans based on these lower returns will be more conservative and help with a re-assessment of retirement lifestyle goals. If we could do this globally, we might get out of this chase the yield trap.

Upcoming events


Canada: Housing starts, new home prices, existing home sales,

US: Producer prices, monthly budget, consumer prices, retail sales, industrial production, University of Michigan sentiment index

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This publication has been prepared by an advisor of ScotiaMcLeod, a division of Scotia Capital Inc. (SCI). This publication is intended as a general source of information and should not be considered as personal investment or tax advice. We are not tax advisors and we recommend that individuals consult with their professional tax advisor before taking any action based upon the information found in this publication. Opinions, estimates, and projections contained herein are our own as of the date hereof and are subject to change without notice. The information and opinions contained herein have been compiled or arrived at from sources believed reliable but no representation or warranty, express or implied, is made as to their accuracy or completeness. Neither SCI nor its affiliates accepts liability whatsoever for any loss arising from any use of this publication or its contents. This publication is not, and is not to be construed as, an offer to sell or solicitation of an offer to buy any securities and/or commodity futures contracts. SCI, its affiliates and/or their respective officers, directors, or employees may from time to time acquire, hold, or sell securities and/or commodities and/or commodity futures contracts mentioned herein as principal or agent. All performance data represents past performance and is not indicative of future performance. SCI and/or its affiliates may have acted as financial advisor and/or underwriter for certain of the corporations mentioned herein and may have received and may receive remuneration for same. All insurance products are sold through Scotia Wealth Insurance Services Inc., the insurance subsidiary of Scotia Capital Inc., a member of the Scotiabank group of companies. When discussing life insurance products, ScotiaMcLeod advisors are acting as Insurance Advisors (Financial Security Advisors in Quebec) representing Scotia Wealth Insurance Services Inc. This publication and all the information, opinions, and conclusions contained in it are protected by copyright. This report may not be reproduced in whole or in part, or referred to in any manner whatsoever, nor may the information, opinions, and conclusions contained in it be referred to without in each case the prior express consent of SCI. 

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