Lower Your Expectations — or Else

Most U.S. public pension plans expect their portfolios to deliver 7 percent-plus returns. Foundations and endowments expect to spend about 5 percent of their assets in real terms without eating into principal. These expectations are not sustainable.

Sure, I have seen these sorts of average returns realized across my 30-year career in investing. But this has also been a uniquely positive environment for asset prices. Interest rates have declined from double digits to near zero. The U.S. economy has delivered average real growth rates of 3 percent, not the likely 2 percent or so going forward. And, most important, corporate profits have been taking a larger and larger share of GDP as wages have lagged.

This last factor is most important. Capitalism has become too successful at enriching capitalists at the expense of ordinary workers. Inequality in wealth and income has returned to the levels of the Gilded Age. Real wages for most Americans have stagnated for decades. Large corporations and the very wealthy have seized disproportionate influence over the political and regulatory processes. Ironically (or sadly), those negative impacts have had very positive effects on returns enjoyed by institutional investors. 

When I was in graduate school, I was taught that labor takes a fixed share of the economic pie. Another economic truism that did not pan out. The labor share of national income has fallen more than 4 percentage points over the past 30 years, while the share going to nonfinancial corporate profits has nearly doubled. This trend continues, and arguably is a bigger sustainability challenge for investors than climate change, as its effects are more obvious and the political reaction will be quicker and more powerful. 

There are many hypotheses about the reasons for increased economic inequality, mostly related to technology and globalization. But the cause matters less for investors than the outcome: Returns to capital (shareholders) have grown faster than the overall economy and have led capital to reap a larger share of economic output. And the impact on equity returns has been enormous. In a recent white paper, Bridgewater estimated that rising profit margins have added about 3 percentage points to U.S. equity returns over the past 20 years. That’s close to 2 percent per year on a typical 60-40 institutional balanced portfolio.

But are these historic increased returns to capital sustainable? Only if you are willing to believe that capital can continue to take a larger and larger share of national income and that it’s acceptable for the distribution of income and wealth to become more and more unequal. The math is not especially hard: Corporate profits equal the profit share of GDP times GDP. Hence the growth rate of profits equals the growth rate of GDP plus the growth rate of the profit share. Using some ballpark numbers, it’s tough to expect U.S. equities to deliver more than a 6 percent average return (a 2 percent dividend yield and 4 percent nominal GDP growth) — and that’s with a constant profit share and payout ratio. With the bond market yielding less than 2 percent, that implies about a 4.5 percent rate of return for a 60-40 balanced portfolio. If you think the profit share should decline, then returns will be lower still.

The inference for institutional investors is subtle but clear. Sure, they should seek to maximize their returns. But investors, and asset owners, have to recognize that they collectively incentivize a financial system that encourages increased returns to capital at the expense of labor. When a foundation or university tells its CIO, consultants, and asset managers it “needs” 7 percent-plus returns to support its spending, does it admit to itself that expected returns in this range require the implicit assumption of a rising profit share? (Or else implausibly high alpha.) When a state retirement system sets a goal of 7 percent-plus returns for its pension plan, does it make clear that this is possible only if American workers continue to suffer stagnating real wages? In either case, the message to corporate America is clear: Cut costs (i.e., wages) and grow profit margins.

Some may argue that investment strategies that direct capital to its most efficient uses will make the economic pie grow faster. Even if capital gets a growing share of the pie, labor’s slice will get larger too. But the data doesn’t support this claim. Real wages across all but the top of the income distribution have been flat for decades, as trend growth rates of real GDP and productivity have slowed by a full percentage point or more. Labor’s slice is not growing. Why should we expect this to change going forward?

To be sustainable, the financial system has to deliver socially and politically “fair” outcomes. The current system is not sustainable in part because institutional investors have built-in spending rules and expected rates of return that depend on ongoing shifts of income from labor to capital — shifts that are encouraging an increasing populist backlash. The institutional investment community faces an important choice: Reset return expectations (and spending commitments) to levels that are consistent with a steady or rising labor share of national income, or else tacitly accept rising inequality, with all the associated social and political risks.

What would a more sustainable investment landscape look like? Asset owners would spend what they earn, not plan to earn what they want to spend. More endowments and foundations would spend down their assets over time. Why is existing in perpetuity so important? Sponsors of public pension plans would admit to themselves, and to taxpayers, that more resources — not high expected returns — will be needed to make good on promises to workers and retirees. And asset managers would be freer to engage with portfolio companies to boost long-term growth outcomes instead of short-term profits. 

Paul O’Brien has worked as an economist and portfolio manager and most recently was deputy chief investment officer at the Abu Dhabi Investment Authority. Feedback?