Pension plans should prepare for low returns, C.D. Howe report suggests

OTTAWA – Retirement savers and pension funds should be prepared for lower investment returns than they had before the financial crisis, a report by the C.D. Howe Institute suggests.

Report authors Steve Ambler and Craig Alexander project a one per cent rate of real return for risk-free investments will form an anchor for the returns on other investments including bonds and stocks.

And while Alexander said that would imply a three per cent return on three-month treasury bills if the Bank of Canada maintains its two per cent inflation target — which would be well ahead of where rates are today — it would be below where it was before the financial crisis and even lower than in the 1990s.

Three-month treasury bills currently earn around 0.42 per cent, however the yield on the same investment was more than four per cent as recently as 2007.

“Today, pension managers would be thrilled with such a return on highly liquid, sovereign-grade assets, and it may seem odd discussing such a high rate at the moment,” said Alexander, a former chief economist at TD Bank.

“Nevertheless, long-term investors, like pension funds, have a multi-decade investment horizon, and the analysis tells us they need to be braced for lower returns than in the past.”

The report noted that an investor hoping to earn a seven per cent annual return won’t be able to do that without taking at least some risk. And with a lower risk-free rate than in the past, that means taking more risk to earn the same return.

The report said the lower risk-free rate will be due, in part, to the impact of the aging population that will weigh on the rate of growth in real income per capita.

With growth in real income per capita expected to average at an annual pace between 0.75 and 1.35 per cent over the next couple of decades, that means the real return on risk-free investments can only be counted on to be close to one per cent, the report said.

Alexander acknowledged that the real risk-free rate today is below the pace of real per capita income growth, but said if economic theory is validated that will change.

“The level of rates today are remarkably low, they are unsustainably low and ultimately there’s going to have to be a rebalancing, but when that rebalancing happens the level of rates is not going to go up to anything like we had before,” he said.

“What it is telling you is that returns on a balanced diversified portfolio could be something in the range of four to six per cent and that’s probably lower than many pension funds are hoping for.”

Note to readers: This is a corrected story: A previous version misspelled ‘Institute’