Following our expected returns methodology, the June 2022 financial planning assumptions update shows that our expected return for fixed income has increased by a whopping 143 basis points – from 2.48% in December 2021 to 3.91% – and the expected return for global factor tilted equities is 47 basis points higher than our last (non-factor-tilted) estimate– from 6.62% to 7.09%. The increase in fixed income expected returns is explained by rising bond yields. For example, the bellwether Government of Canada 10-year bond yield has more than doubled from 1.42% to 3.23% during the first semester of 2022, one of the fastest yield increases in history. Data shows that bond yields are very effective at predicting future fixed income returns.
The primary reason for the change in equity expected return is the integration of a multifactor expected return premium for portfolios using Dimensional Fund Advisors equity funds, which added 35 basis points net of product fees. The decline in stock prices from December 2021 to June 2022 explains the remaining 13 basis points of expected return increase. Based on these changes, our clients’ financial planning projections have improved, in some cases dramatically. Another way to think about the positive change in financial position is that our clients’ future consumption liabilities are much more sensitive to changes in yields than their financial asset portfolios.
We stress that financial projections are based on assumptions about the future value of several variables, some of which are extremely difficult to forecast. While we have seen a positive boost over this period, mostly from rising bond yields, we know from recent history that yields can fall. Falling yields would have a negative impact on financial plans. We believe that the best way to counter the potential effects of forecasting error is through frequent financial planning updates.
To benchmark our assumptions, we compare them to the assumptions of FP Canada (updated April 30, 2022) and AQR (updated Q1, 2022). We compare asset classes and portfolios with equivalent geographic allocations. In the case of AQR we additionally compare factor tilted and un-tilted assumptions. Our biggest difference is in fixed income which is largely attributed to our data being updated in June 2022, after a recent jump in yields. Both FP Canada and AQR are using data as of December 2021 and, in the case of FP Canada CPP and QPP actuarial assumptions from December 2018 are used.
Table 1 – Fixed Income Expected Returns
| PWL Real | AQR Real* | FP Canada Real | |
| Fixed Income | 1.57% | -0.16% | 0.69% |
FP Canada finds a 0.69% real expected return for fixed income, nearly a full percentage point below PWL’s assumption. FP Canada’s fixed income assumption is derived from a simple average of CPP and QPP’s annual fixed income expected return for the years 2019 through 2048 less a 0.75% deduction “to account for the opportunity of the QPP and CPP to buy and hold fixed-income for significantly longer than the typical holding period of individuals,” and the 2021 FP Canada/IQPF Survey. FP Canada finds that using lagged actuarial data provides more stability in their assumptions. However, given the strong predictive power of current yields for 20-year fixed income returns, we prefer to update our assumptions based on these data as they become available. Additionally, we do not find FP Canada’s 0.75% downward adjustment to be necessary given that CPP assumes that “average maturity is set at 7.0 years for federal bonds and 13.5 years for provincial bonds” while Canadian aggregate bonds (the current basis of our expected return) have an average maturity above 10 years. FP Canada also appears to be using the actuarial assumptions for government bonds while ignoring credit. Canadian aggregate bonds are approximately 30% corporate. CPP’s assumption for aggregate bonds, including credit is about 0.50% higher in equilibrium than for government bonds. Importantly, CPP’s 2018 assumption was that real fixed income yields would gradually increase to 2.7% between 2018 and 2029. We have seen real yields (using breakeven inflation) exceed this level in 2022.
AQR finds a -0.4% real expected return for Canadian 10-year government bonds and a 0.4% real expected return for US investment grade debt. Their estimates are heavily influenced by market yields. At June 30th, nominal on Canadian 10-year nominal bonds were 3.23%% compared to the 1.4% used by AQR to arrive at their -0.4% assumption. Given these changes, and assuming market conditions stay as they are now, we expect AQR’s next update to resemble our estimate more closely. AQR takes the position that “government bonds’ prospective medium-term nominal total returns are strongly anchored by their yields.”
Table 2 – Equity Expected Returns
| PWL Real | AQR Real | FP Canada Real | |
| Global Equities* | 4.34% | 3.93% | 4.37% |
For market capitalization weighted equities, we find for common geographic regions that our estimates are roughly in line with FP Canada and AQR. AQR relies more heavily on market-based assumptions which tended to reduce their estimates. From December 2021 to June 2022 PWL’s estimate increased 0.13% due to falling equity valuations. AQR’s estimate is reflective of December 2021 data and we expect the gap in expected returns between PWL and AQR will narrow at their next update. FP Canada has minimal market-based input to their equity expected return assumptions. They again use CPP and QPP assumptions, survey results, and 50-year historical returns. These data sources are equal weighted and an additional safety margin of 0.50% is deducted “to compensate for the variability of the long-term returns.” PWL’s estimates do not include a comparable safety margin as our estimates are designed to be used in Monte Carlo simulations which account for the variability in returns. Adding the 0.50% safety margin back to FP Canada’s estimates puts them well above both PWL and AQR.
Table 3 – Factor Tilted Expected Returns
| PWL Real | AQR Real Multifactor | AQR Real Value | |
| Global Equities (Tilted)* | 4.69% | 4.93% | 4.43% |
Factor tilted portfolios are structured to capture the returns of higher expected returns securities by increasing their weight relative to a market capitalization weighted portfolio. Typical characteristics related to expected returns are company size, relative price, profitability, and investment. PWL uses factor tilted portfolios from Dimensional Fund Advisors. FP Canada does not report expected returns from factor premiums. AQR reports both value-tilted and multifactor premiums. For a long-only value portfolio “that is carefully implemented and reasonably priced” they assume a net of fee expected real return 0.5% higher than the cap-weighted index, with 2-3% tracking error. For a multifactor portfolio assumed to have “balanced allocations to value, momentum and defensive styles” they assume a net premium of around 1% with similar tracking error. At 0.35% net, PWL’s multifactor premium is a conservative estimate relative to AQR’s assumptions. At the portfolio level, our equity expected return with factor tilts is between AQR’s value tilted and multifactor expected returns.
We believe that, given current market conditions, our expected return assumptions are reasonably in line with both FP Canada and AQR. The world has changed from December 2021 through June 2022, and we believe it is sensible to reflect these changes in financial plans. The improving financial positions of our clients is not unique. Pension consultants Mercer and AON have seen the pension plans that they track increase their funded status by a wide margin over the same period.
In the end, good financial projections are based on assumptions. They can provide solid guidance, but they are never completely accurate because no one can predict the future. There always is a forecasting margin of error. The best way to counter the potential negative effects of those forecasting errors is to update your financial plan annually and adjust your saving/spending with moderation when appropriate.
