What does end of ‘golden era’ of equity returns mean for pension investors?

Most of today’s investors have lived through a ‘golden era’ of equity returns that is about to come to a shuddering halt.

So argues an influential report by global consultancy McKinsey, which warns anyone looking to build a retirement pot over the next 20 years will need to do more of the legwork themselves, rather than relying on the stockmarket or their fund manager.

But what is driving this new reality? And what can savers do about it?

A perfect storm

According to the McKinsey report, real total equity returns – including capital growth and dividends – averaged 7.9% in both the United States and Western Europe between 1985 and 2014. These were 140 and 300 basis points (or 1.4 and 3 percentage points) above the 100-year average.

Similarly, real bond returns in the same period averaged 5% in the US, McKinsey says, 330 basis points above the 100-year average, and 5.9% in Europe, 420 basis points higher than the average.

How exactly has this happened? Well, a favourable combination of economic and business trends drove a 30-year spell of exceptional  returns for investors.

Inflation and interest rates tumbled from high levels in the 1970s and 80s, while GDP growth was strong, boosted by demographic shifts, productivity improvements and the rise of China as an economic force. Corporate profits have surged too, reflecting revenue growth from new markets, falling business taxes, and plummeting costs as firms harnessed the benefits of automation and global supply chains to cut costs.

Some of these trends have now run their course, the report argues. Inflation and interest rates can’t go much lower, while GDP growth could stagnate as productivity gains stall. And while digitization has boosted margins for big corporates over the last 30 years, it is now allowing emerging companies to exert greater competitive pressures on their larger rivals.

But what does this all mean for investors?

In its ‘slow growth’ scenario, McKinsey estimates total US equity returns will average between 4% and 5% over the next two decades – 250 basis points lower than the 1985-2014 average. Fixed interest returns could be just 1%, a whacking 400 basis points lower, while even the ‘high growth’ scenario sees the next 20 years significantly underperform the previous 30. The analysis for Europe is equally gloomy.

The grim reality

While clearly nobody has a crystal ball, to my mind the McKinsey analysis provides a welcome reality check for retirement investors. Although equity and bond returns will vary depending on your individual portfolio choices, the figures quoted in the report provide a useful benchmark for anyone making plans for their financial future.

There are no magic solutions to plug the gap between the last 30 years and the next 20 years, however. If, as McKinsey predicts, long-term yields are lower, investors will need to work harder to enjoy a retirement similar to those that went before.

That ultimately means paying more in, working longer or taking more investment risk (and accepting your fund value can go down as well as up).

A tough message perhaps, but once again it just emphasises the importance of having a realistic retirement plan in place so you aren’t a hostage to the fortunes of investment markets.