What Stock Market Returns to Expect for the Future?
All three proposals of the 1994–96 Advisory Council on Social Security included investment in equities. For assessing the financial effects of these proposals, the Council members agreed to specify a 7.0 percent long–run real yield from stocks. They devoted little attention to possibly different short–run returns from stocks. The Social Security Administration ’s Office of the Actuary (OACT) used this 7.0 percent return, along with a 2.3 percent long–run real yield on Treasury bonds, to project the impact of Advisory Council proposals. Since then, the OACT has generally used 7.0 percent when assessing other proposals that include equities. In the 1999 Social Security Trustees’ Report, the OACT used a higher long–term real rate on Treasury bonds of 3.0 percent. In the first 10 years of its projection period, the OACT makes separate bond rate assumptions for each year, with slightly lower assumed real rates in the short run. Since the assumed bond rate has risen, the assumed equity premium, defined as the difference between yields on equities and on Treasuries, has declined to 4.0 percent in the long run. Some critics have argued that the assumed return on stocks —and the resulting equity premium —are still too high.
This issue in brief examines the critics’ arguments and considers a range of assumptions that seem reasonable rather than settling on a single recommendation. First, the brief reviews the historical record on rates of return and the theory about how those rates are determined. Then, it assesses the critics’ arguments concerning why the future might be different from the past. The reasons include: 1)recent developments in the capital market that have reduced the cost of stock investing and led to broader ownership; 2)the current high value of the stock market relative to various benchmarks; and 3)the expectation of slower economic growth in the future. In this discussion, it is important to recognize that a decline in the equity premium need not be associated with a decline in the return on stocks, since the return on bonds could increase. Similarly, a decline in the return on stocks need not be associated with a decline in the equity premium, since the return on bonds could also decline. Both rates of return and the equity premium are relevant to choices about Social Security reform. Finally, the brief considers two additional issues: 1) the difference between gross and net returns; and 2) investment risk.