The long-term equity risk premium (ERP) has a much higher degree of volatility than established thinking holds to be true, according to new research by Drew, Walk & Co.
It claims while the average ERP in Australia is around 6 per cent (though it has been below its long-term average since 1990) the wide distribution of returns on 20-year periods was an often-overlooked aspect in the design of retirement products, putting members at risk.
The research examined the equity return performance over government bonds for 20-year periods from 1900–2015, and found that equity risk is not guaranteed to be adequately rewarded, with negative performance occurring in several instances.
“If you had told me at the start of this process we would have been serving up for you negative ERPs over a period of 20 years I wouldn’t have believed you. We were absolutely shocked that at how, even if you closed down for a 20-year window, you could still get a negative risk premium,” said Michael Drew, director of Drew, Walk & Co, and professor of finance at Griffith University.
He added that while most people are correct in saying the ERP in Australia is around 6 per cent, it doesn’t cover the huge distribution of outcomes, drawing the analogy of assuming a river was safe to cross because the average depth was only 1 metre to illustrate his point.
“We talk a lot about the number, around 6 per cent; I think we should be talking more about the distribution,” Drew said.
For example, if you were invested in the Australian share market from 1960–1980, the average performance over government bonds was 8.3 per cent a year. The next period, 1980–2000, gave a performance of -0.6 per cent a year.
Jeremy Cooper, chair of retirement income at Challenger, which commissioned the report, said: “You do see a lot of commentators saying things like equites will always outperform over the long-term. This is simply not the case.
“A key message to come from this is that a long time does not necessarily diversify the risk that you take by investing in equities. Annual returns average out – there’s a reversion to the mean – but your actual outcome can vary considerably.”
Cooper cautioned that in building a retirement income solution, equity risk premiums could not be relied on, even over a 20-year period.
“People do need equities in retirement, but you can’t set and forget. You also can’t rely on these historical averages as being a sure bet,” Cooper said.
Drew added that in the accumulation phase, time is a friend, but in the deaccumulation phase, time is a big challenge.
“Part of the answer, part of what comes out of this work, is an understanding of the unpredictability of the equity risk premium and how we might think about that in the context of the core retirement income liabilities we are trying to meet,” Drew said.