What Stock Market Returns To Expect For The Future?

Over the long term, stocks have earned a higher rate of return than Treasury bonds. Therefore, many recent proposals to reform Social Security include a stock investment component. In evaluating these proposals, the Social Security Administration’s Office of the Actuary(OACT) has generally used a 7.0 percent real return for stocks (based on a long-term historical average) throughout its 75-year projection period. For the return on Treasury bonds, it currently assumes some variation in the initial decade followed by a constant real return of 3.0 percent. Therefore, its current assumption for the equity premium, defined as the difference between yields on equities and Treasuries, is 4.0 percent in the long run. Some critics contend that the projected return on stocks—and the resulting equity premium—used by the OACT are too high. It is important to recognize that there are two different equity-premium concepts. One is the realized equity premium, measured by the rates of return that actually occurred. The other is the required equity premium, which is the premium that investors expect to receive in order to be willing to hold available amounts of stocks and bonds. These are closely related but different concepts and can differ significantly in some circumstances. Over the past two centuries, the realized equity premium was 3.5 percent on average, but it has increased over time. For example, between 1926 and 1998, it averaged 5.2 percent. The increase is mainly due to a significant decline in bond returns, since long-term stock returns have been quite stable. The decline in bond returns is not surprising given that the perceived risk of federal debt has dropped substantially since the early nineteenth century. Based on an initial look at historical trends, one could argue for a somewhat higher equity premium than the 4.0 percent used by the OACT. Critics argue, however, that the OACT’s projections for stock returns and the equity premium are too high. These criticisms are based on three factors: (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.