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63 Soc. Sec. Bull. 38 (2000)
What Stock Market Returns to Expect for the Future

handle is hein.journals/ssbul63 and id is 144 raw text is: PESPETIE High stockprices, together with projected slow economic growth, are not consistent with the 7.0 percent return that the Office of the ChiefActuary has generally used when evaluating proposals with stock investments. Routes out of the inconsistency include assuming higher GDP growth, a lower long-run stock return, or a lower short-run stock return with a 7. 0 percent return on a lower base thereafter. In short, either the stock market is overvalued and requires a correction tojustify a 7. 0 percent return thereafter or it is correctly valued and the long-run return is substantially lower than 7. 0 percent (or some combination of the two). This article argues that the former view is more convinc- ing, since accepting the cor- rectly valued hypothesis implies an implausibly small equity premium. This article originally ap- peared as an Issue in Brief of the Center for Retirement Research at Boston College (No. 2, Sep- tember 1999). The research re- ported herein was performed pursuant to a grant from the Social Security Administration (SSA) funded as part of the Re- tirement Research Consortium. The opinions and conclusions expressed are solely those of the author and should not be con- strued as representing the opin- ions or policy of SSA, any agency of the federal government, or the Center for Retirement Research at Boston College. *The author is a professor at the Massachusetts Institute of Technology. (Manuscript received November 1999; submitted for external review December 1999; revise and resubmit recommended April 2000; revision received June 2000; paper accepted July 2000.) What Stock Market Returns to Expect for the Future? by Peter A. Diamond* Summary In evaluating proposals for reforming Social Security that involve stock investments, the Office of the ChiefActuary (OCACT) has generally used a 7.0 percent real return for stocks. The 1994-96 Advisory Council speci- fied that OCACT should use that return in making its 75-year projections of investment- based reform proposals. The assumed ultimate real return on Treasury bonds of 3.0 percent implies a long-run equity premium of 4.0 percent. There are two equity-premium concepts: the realized equity premium, which is measured by the actual rates of return; and the required equity premium, which investors expect to receive for being willing to hold available stocks and bonds. Over the past two centuries, the realized premium was 3.5 percent on average, but 5.2 percent for 1926 to 1998. Some critics argue that the 7.0 percent projected stock returns are too high. They base their arguments on recent developments in-the capital market, the current high value of the stock market, and the expectation of slower economic growth. Increased use of mutual funds and the decline in their costs suggest a lower required premium, as does the rising fraction of the American public investing in stocks. The size of the decrease is limited, however, because the largest cost savings do not apply to the very wealthy and to large institutional investors, who hold a much larger share of the stock market's total value than do new investors. These trends suggest a lower equity premium for projections than the 5.2 percent of the past 75 years. Also, a declining required premium is likely to imply a temporary increase in the realized premium because a rising willingness to hold stocks tends to increase their price. Therefore, it would be a mistake during a transition period to extrapo- late what may be a temporarily high realized return. In the standard (Solow) economic growth model, an assumption of slower long- run growth lowers the marginal product of capital if the savings rate is constant. But lower savings as growth slows should partially or fully offset that effect. The present high stock prices, together with projected slow economic growth, are not consistent with a 7.0 percent return. With a plausible level of adjusted dividends (divi- dends plus net share repurchases), the ratio of stock value to gross domestic product (GDP) would rise more than 20-fold over 75 years. Similarly, the steady-state Gordon formula-that stock returns equal the adjusted dividend yield plus the growth rate of stock prices (equal to that of GDP)- suggests a return of roughly 4.0 percent to 4.5 percent. Moreover, when relative stock values have been high, returns over the following decade have tended to be low. To eliminate the inconsistency posed by the assumed 7.0 percent return, one could assume higher GDP growth, a lower long-run stock return, or a lower short-run stock return with a 7.0 percent return on a lower base thereafter. For example, with an adjusted dividend yield of 2.5 percent to 3.0 percent, Social Security Bulletin • Vol. 63 • No. 2 ° 2000

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